Recently, I had the opportunity in London to attend a fascinating two day course, “A Practical History of Financial Markets”, hosted by CLSA’s Russell Napier, for some time already one of my favourite market analysts.
Much of the course is dedicated to answering just one question: is it possible to value the stock markets? Central bankers believe we can’t. On 5 December, 1996, the then Fed chairman Alan Greenspan famously asked, “How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”
That “irrational exuberance” phrase was given to him by an economist, Professor Robert Shiller of Yale University. The stock market didn’t much like the term. It went into an immediate swoon, and a chastened Greenspan never mentioned the value of the stock market again.
Shiller coined the phrase “irrational exuberance” for the title of a great book, published in March 2000. It nailed the all-time high for the US stock market almost to the day.
Unlike central bankers, Shiller believes you can value the stock market, and his preferred measure is a ratio known as the cyclically adjusted price/earnings ratio, or ‘Cape’. What is the CAPE saying today? Well, it’s not pretty.
Two flashing warning lights
Cape is similar to the simple price/earnings ratio, but tends to taken across the stock market as a whole, and it uses an average price over the prior ten years, which smooths out the shorter-term volatility and noise.
And when you look at the Cape chart below, three peaks jump out: 1901, 1929 and 2000. In each case, Cape was well above its historic average, and in each the market crashed.
More to the point, around 23 or 24 times has tended to be the peak valuation in Cape, with 1929 and 2000 being extreme outliers.
Cyclically adjusted p/e for the US stock market, and long term US interest rates
So where are we now, at least in terms of the US stock market?
The market trades at over 24 times historic earnings. That strongly suggests that US stock markets are significantly overvalued. Given that the US stock market is also the largest in the world, any decline in US stocks is likely to have a gravitational impact on stock markets internationally.
But note, too, that Shiller has added the trend in long-term US interest rates to the chart. On casual consideration of the data, it’s clear that there is no obvious correlation between interest rates and equities. But what concerns me is the fact that the most recent major equity bull run (between 1980 and 2000) coincided with a decline in US interest rates.
Interest rates are now close to their all-time lows (though they’ve backed up rather ominously since July last year). So what I am suggesting is not just that US stock markets are overvalued, but that they also face a dual headwind of possibly rising long-term interest rates.
In any event, they certainly cannot count in the future on interest rate support like they enjoyed during the bull run of 1980 to 2000.
I believe that the Cape ratio is as good a measure of assessing broad market valuation as any. The problem, as always, is with timing. Cape doesn’t necessarily have much value over the short term as a timing tool. It merely identifies when the market seems to be heavily overvalued. It may take some time for that overvaluation to become manifest through lower prices.
Another measure of assessing stock-market valuation is the Q ratio, or Tobin’s Q, named after the Nobel laureate James Tobin of Yale University.
Tobin suggested that the combined market value of the companies listed on the stock market should be roughly equal to their replacement cost (ie, if you sold all of the companies’ assets and wound them up). Most of the time, Q is below one and it tends to revert to a mean of roughly 0.7.
Economist Andrew Smithers assessed the latest Q figure for the US market to be 1.01 at the end of March this year. He suggests that US non-financial stocks are overvalued to the order of roughly 58%.
Like Shiller, Andrew Smithers also published a book in 2000 warning of significant overvaluation in the stock market. His book was titled Valuing Wall Street: Protecting Wealth in Turbulent Markets. Astonishingly, this book was also published in March 2000, and its back cover bore the following warning:
“The US stock market is massively overvalued. As a result, the Dow could easily plummet to 4,000 – or lower – losing more than 50% of its value, wiping out nest eggs for millions of investors. So argue Andrew Smithers and Stephen Wright in Valuing Wall Street: Protecting Wealth in Turbulent Markets. Using the Q ratio developed by Nobel Laureate James Tobin of Yale University, Smithers & Wright present a convincing argument that shows the Dow plummeting from recent peaks to lows not seen in a decade. Using Q, Smithers & Wright show convincingly and conclusively why today’s stocks are dangerously overvalued, and what you can do to protect your assets from the dramatic downturn that is a virtual certainty.”
And apart from Russell Napier, who else presented at last week’s “Practical History of Financial Markets” course? Andrew Smithers and Stephen Wright. Andrew has also followed up on his earlier book with a 2009 update, Wall Street Revalued: Imperfect Markets and Inept Central Bankers.
So, we now have two separate measures for assessing the valuation of the US stock market: Cape and Q. Both of those signals are flashing red.
And the problem of apparent market overvaluation is compounded by the central banks. Both stock markets and bond markets are now tools of central bank policy. Governments and their central bank stooges have been printing money to drive these markets higher, in an attempt to stimulate the economy.
In the process, they have boosted property prices, which is doubly ironic when you think that a property market bubble was one of the causes of the financial crisis in the first place.
Our own government has hardly been immune from this facile trend: the Conservatives announced ahead of their party conference that they brought forward the second phase of their ‘Help to Buy’ scheme, which allows people to get 95% mortgages.
Encouraging people onto the housing ladder with property prices arguably significantly overvalued is madness.
After the end
So in a sense, we are trapped. The sensible thing would be to shelter, at least in part, in bank deposits. But the banking crisis has done two things. It has revealed just how shaky the banking sector is, and the zero interest rate policy effectively adopted by most major Western central banks has made cash a notably unattractive asset, as latent inflationary pressure builds.
But as I’ve said before, we have to play the hand we’re dealt. It strikes me that if there were ever a time to have all your investment eggs in one basket, now is not that time.
The future is simply too uncertain. Will market interest rates rise? Probably over the longer term, but the short-term outlook is like staring through a thick fog. Russell Napier points out that as things stand today, deflationary pressure is actually in the ascendant.
Despite trillions in quantitative easing (QE), US bank credit already seems to be contracting again, and there are early signs of real crisis in emerging markets. Russell suggests, and I wholeheartedly agree, that QE has been a colossal failure.
The Fed has printed over $3trn in new money. Despite that stimulus, the Fed’s preferred measure of inflation, the price index of personal consumption expenditures (PCE inflation), stood at close to an all-time low of just 1.1% in July of this year.
Where inflation has returned has been in financial asset prices and property prices. But the real economy remains on life support.
So governments and central banks are now the investor’s enemy. In pumping up asset prices they are badly distorting the markets in just about everything. What are we to do?
My answers remain consistent. Diversify sensibly across asset classes. Objectively high quality bonds will offer some protection against whatever the future holds, and may even perform well in an outright debt deflation, which Russell Napier considers a growing possibility.
Rather than abandon the stock market entirely, limit your equity investments or funds to those with compelling valuations and defensive characteristics. But if the combined signals of Cape and Q are to be believed, it makes complete sense to limit severely your equity market exposure.
And then supplement these investments with ones that behave in completely different ways: absolute return funds, for example, and real assets, such as gold and silver.
Property has not featured (yet) in my Price Report Portfolio, because I suspect that most subscribers already have some exposure to the sector if they own a home. But it may do at some point, if I can identify sufficiently attractive valuations in an easily affordable format.
I note that the Swiss fund manager Marc Faber, for whom I also have profound respect, recently recommended the following asset allocation:
• About 25% in equities
• 25% in fixed income, securities and cash
• 25% in real estate
• 25% in precious metals, gold and silver
And it’s interesting to read how he views his gold. He doesn’t bother watching its day-to-day price gyrations: “I have it [gold] and it’s my insurance policy. It is important that one day when the so-called s**t hits the fan – and I think the Fed is well on its way to creating that situation – you have access to your gold, that it is not taken away.”
This is an uncomfortable investment environment, certainly the most challenging I have ever experienced in the nearly quarter of a century I’ve spent in the capital markets. But again, we must play the hand we’re dealt.
Most importantly, we must outlive a rotten monetary system, with governments and central banks behaving like criminals. How long will we have to wait? Alas, that is one question I cannot answer.