Here’s a quiz for you.
The Nasdaq has just passed its pre-crisis high. It trades on an average price/earnings (p/e) ratio of around 25 times – with a tiny dividend yield of under 1.5%.
The S&P 500 index has risen nearly 27% so far this year. Into this market, 192 companies have recently issued new shares, raising a total of $51.8bn – a number not far off that raised back in the 2000 dotcom bubble. Based on last year’s profits, the p/e ratio has risen from 16.4 times to 19.1 times over the same period. This is not about companies being worth more. It is about people paying more.
The index, as Christopher Wood of CLSA points out, is also trading on a cyclically adjusted p/e ratio or Cape – a measure which is based on the average of the last ten years’ earnings – of 25 times. The long-term average is more like 16 times.
It’s been higher, much higher – think 44 times in 2000 and 33 times in 1929. But it is, says Wood, “just exceeding the highs reached in 1901 and 1966”. Nasty market falls – 20-year bear markets in fact – followed both of those peaks.
So here’s my question: would you call this market: a) a bubble, b) pretty expensive, but not yet a bubble, c) different to any market that has gone before it in myriad complicated ways, or d) a stock picker’s market?
If you are a normal person, you will have gone for a or b. If you are a fund manager, an analyst working for a stockbroking firm or someone who is hoping to be one of those things at some point in the future, you will have gone for c or d.
How do you justify a market that is clearly overpriced, on any conventional or historical measure? You announce that thanks to some change or another – demographics, accounting rules, technology, one-off crises, shale gas, the fact your kids’ school just put the fees up by 9%, whatever – it should be henceforth valued in a new way.
If you can’t delude yourself to that extent, then you announce that while the market as a whole might be ‘fully valued’ (or perhaps ‘at richer valuations’), you still feel able to find stocks that will rise forever.
Since it’s just been the Thanksgiving weekend, let’s be charitable: most people in the financial industry have no choice but to either believe, or to pretend to believe, this kind of ‘new paradigm’ stuff, since their careers and those school fees depend on it.
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Self delusion is all part of the job. So here we have the JPM US Equity Income Fund manager commenting: “Share valuations have risen to fair to slightly high levels. The next phase will be characterised by differentiation and stock selection.”
Then there is Hargreaves Lansdown on the ‘Santa rally’ (the tendency of markets to rise in mid to late December): “Stock pickers should be able to add significant value and help portfolios outperform over the longer term.” And just for good measure, here’s Schroders taking the theme across the water: “The European market in 2014 will be one for stock pickers.”
On the valuation front, I won’t bore you with too much of the debate on whether Cape is relevant to the modern world or not. But here’s a fairly typical fund manager claim that it isn’t: “That ratio when applied to the last decade cannot be expected to correctly account for the enormous anomaly of the financial crisis . . . we vehemently believe that the last four quarters are a better indication of the next four, than the last ten years are.”
That may be true. And it sounds good too. But here’s the counter claim: there have been all sorts of anomalies knocking around the market over the past 100 years and the Cape has – so far – always been a good indicator of likely future returns. I’m with history on this one.
The truth – and this is one of those rare occasions in market where there is a truth – is that the rise in the US market isn’t about anything fundamental. It’s about quantitative easing (QE).
Those in any doubt need only look at a chart of the index next to one of the expansion of the Federal Reserve balance sheet: the more bonds they buy (via QE) the more the market goes up.
Last year, I wrote that QE would always be a buy signal. Sell a bond to a central bank who buys it with new money and you have cash. You use that cash to buy something, another bond maybe, or a few shares in Twitter or perhaps some defensive income equities you have carefully stock-picked.
Then whoever you bought from has the cash. He buys something too. And so the cash jumps from player to player – think of it as a hot potato going from hand to hand – sprinkling a little bubble dust on everything as it goes. It’s still doing that.
I’m beginning to feel rather as if I am repeating myself on this subject, but the key to everything at the moment is this. Not all markets are obviously overpriced. The US is. It will stay that way – driving the nation’s fund managers to increasingly absurd heights in their attempts to justify it – until US monetary policy shifts. No one knows for sure when that will be.
If you invest at the moment you are betting on monetary policy. That’s fine – I’m doing it too – but you need to be clear that’s what you are doing. It isn’t a bet on fundamentals. It’s a bet on policy, and that can turn around fast. Just ask the stock pickers holding UK housebuilders.
Last week they, were congratulating themselves on their stock-picking skills as housebuilders continued to soar. This week, Mark Carney pulled funding for lending from the mortgage market. And they lost 9% on their holdings in Barratt Developments in a couple of hours. Whoops!
• This article was first published in the Financial Times.
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