Merryn's Blog

Where 'financial excess mark II' is heading

We know how the last financial market boom imploded horribly in the wake of massive excesses. Now it's happening again.

Are you a bit baffled by the ongoing American share price boom?

It wouldn't be surprising if you were.As we've pointed out in Money Morning, it hasn't been based on a big bounce in real US economic activity. America's March industrial output grew just 0.1%, and last week's 'initial jobless claims' were supposed to drop to 430,000 from 460,000, according to the experts surveyed by MarketWatch. But the number jumped to 484,000.

Subscribe to MoneyWeek

Become a smarter, better informed investor with MoneyWeek.

OK, Easter may have distorted the figures. Yet here are more signs that the American economy still isn't picking up enough to create the jobs needed for a genuine long-term recovery. Even Federal Reserve boss Ben Bernanke, who's hates not being bullish, is still being quite cagey about the strength of any rebound.

So what's going on in the US stock market? There are two main reasons for the recent major rally.

Advertisement - Article continues below

First, there's a big re-rating underway. This is when investors chase up share prices faster than the growth rate of company profits. In other words, stock valuations are now climbing sharply. Re-ratings tend to be driven by low interest rates like at present. But there's a limit as to how far the current valuation boost can continue. As David Rosenberg of Glusken Sheff says, now "we have the most overextended equity market in 24 years on our hands".

As for the second reason, look at the chart below.


The red line shows nominal GDP, i.e. the actual level of America's output. It's going nowhere fast. Nor is the green line the trend in profits made by US companies outside the financial sector doing a great deal better.

The yellow line is by far the most interesting. This shows the profits being made by America's financial firms. And as you can see, despite the whole credit crisis, etc, these are right back to boom time again. This is largely due to record low US interest rates, as financial firms can borrow for next to nothing while making massive margins on their lending and investing.

But it flags plenty more trouble ahead.

Almost two years ago, Jim Reid at Deutsche Bank reckoned that US banks had made "excess profits" of some $1.2 trillion in the previous decade compared with how much they "should" have made based on economic growth. He also said that those excesses would be wiped out as they since have been. American financial firms have written down the value of their assets by about $1.15 trillion.

Advertisement - Article continues below

"It seems incredible that financials are now scaling their 2006/07 heights again", says Reid. "The dramatic imbalances are reoccurring".

In other words, the bankers and their friends are right back to their old ways. They're taking ever-larger risks in pursuit of even bigger profits. And Mr Bernanke and his henchmen have given them a very big helping hand. The sector's profit bubble may be driving up share prices for the moment and making many bankers much richer in the process.

Yet we know how the last financial market boom imploded horribly in the wake of massive excesses. This one is heading the same way.




Why Wall Street has got the US economy wrong again

The hiring slowdown does not signal recession for the US economy. Growth is just moving down a gear, says Brian Pellegrini.
25 Oct 2019

The US economic downturn: it’s only a matter of time

With the US economy facing headwinds from trade wars to slowing global growth, talk of a recession is picking up.
22 Feb 2019

Most Popular

Stock markets

Here’s what really matters for markets in 2020

The current geopolitical turmoil is making headlines. But it isn’t particularly significant for investors, says John Stepek. What matters more is how …
10 Jan 2020

Mindfulness and wellbeing: the relentless, creepy rise of the enforced happiness industry

The evidence suggests we’ve never been richer or healthier, yet we are always being told how stressed and discontented we are. Jonathan Compton assess…
9 Jan 2020

A look at the state of Iran’s feeble economy

The Islamic Republic is a big player in regional geopolitics, but its economy is weak, its people in revolt and its enemies growing bolder. Simon Wils…
11 Jan 2020

UK property prices are in the doldrums

House prices barely rose in 2019. Good news, says Nicole Garcia Merida.
9 Jan 2020