A bull market on borrowed time

Has the US Federal Reserve made a mistake? America’s central bank slashed interest rates by 0.5 percentage points last month, an unusually dramatic move designed to pre-empt an economic slowdown. But recent data suggests that cut may have just poured fuel on to the fire. Investors have been treated to a “string of hot data” from the world’s biggest economy, says Matthew Fox for Business Insider. Jobs growth is strong and retail sales “solid”.

The Atlanta Fed estimates that US GDP grew at an annual pace of 3.4% in the third quarter, hardly the sign of a stalling economy. That is prompting a rethink about how fast the Fed will cut rates. The US 10-year Treasury yield, which reflects expectations about future rates, has risen from 3.6% in September to 4.2% now. “The Fed was too dovish when it cut,” says a note from Yardeni Research. Overly easy monetary policy is “raising the odds of a stock market melt-up”.

The opposite of a meltdown, a “melt-up” describes a scenario where stock prices rise sharply as investors dash into shares. On Wall Street, “the party just keeps on going”, says Teresa Rivas in Barron’s. The S&P 500 stock index has notched up 47 record closes this year and has now risen for six weeks straight – its best “winning streak” since the end of last year.

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Is a fall coming?

Yet sceptics say that things are “too good to last”. US investors have become accustomed to “double-digit gains” every year in their equity portfolios, but they should prepare for disappointment, says Torsten Slok of Apollo Global Management. He thinks that on a current forward price/earnings (p/e) ratio of just under 22, the S&P 500 could be heading for underwhelming 3% annualised returns over the next three years, at least if history is any guide.

Goldman Sachs has also been sounding the valuation alarm, says David Crowther for Sherwood News. High valuations bring returns forward from the future, sapping the potential for further gains. Smooth out earnings over the economic cycle and you get the cyclically adjusted price/earnings (CAPE) ratio. Since 1940, the US CAPE has averaged 22, but it now stands closer to 40. The S&P 500 has more than tripled over the last decade, but analyst David Kostin thinks that the coming one will be much worse. He predicts that the S&P will serve up an annualised “nominal total return of 3% during the next 10 years”, which would be a historically weak decade of performance.

Disconcertingly, the “S&P is more expensive than on the eve of the Great Crash in 1929”, says John Authers on Bloomberg. That doesn’t mean you should sell everything. Valuations are not a tool for market timing, since an “irrationally expensive market can always get more expensive”. Many on Wall Street are feeling bullish about the next 12 months. But over “periods of a decade or more”, starting valuations are a decent predictor of returns. The current valuation signal from US stocks is clear: “Over 10 years, it suggests they’ll lag other countries’ stocks, and won’t do very well compared with bonds”.

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