Financial markets kicked off 2018 with the same vigor that closed out 2017, rising strongly in January before running head first into the volatility that has recently injected some uncertainty into prospects for the rest of the year. Now that the dust from that 10% correction is settling, investors are readjusting their glasses to see what if anything has changed in the underlying fundamentals that supposedly drive these markets. At first glance, the answer would seem to be "not much".
There is an assumption in the consensus that economic growth will remain firm or even accelerate globally, and financial indicators are confirming that view. Earnings are expected to rise in the US by almost 20%, driven by the unprecedented mix of aggressive fiscal policy and still-loose monetary settings. Bond yields are rising and equities have clawed back most of the losses of early February, while market darlings like Amazon are making record highs. Absent a real inflation scare—as opposed to the one-off rises in CPI, PPI and wage inflation that accompanied the recent ructions—it seems like 10 year yields in the US around 3% are not a deterrent to continued rallying in stocks.
The difficult part of situating today in the trajectory of the market rally that kicked off in 2009 is that we have enjoyed such a long run of gains, with only brief and shallow corrections along the way. With central bank accommodation---a key force behind the global rally in stocks-- being withdrawn now in the US, not questioning the sustainability of the rally seems irresponsible. We look for possible explanations that would justify a higher plateau of valuations and an extension of what feels like a late stage ‘blow off’. These include increasingly dominant market positions of companies like Amazon, Nvidia and Facebook in the US, Alibaba and Tencent in China, to cite just a few. They also include lower interest rates for longer, which through discounting of earnings would justify higher price multiples of earnings. We also consider interesting accounting notions being put forward that assets like computers will reverse the negative effect of depreciation on a company’s earnings since artificial intelligence and machine learning increase the value of that computer over time rather than the opposite.
Are stocks expensive? The recent correction brought earnings multiples on the S&P down from above 18 to 16, measured on forward earnings forecasts. That seems undemanding. On the other hand, the CAPE measure (based on trailing real earnings over ten years) tells us that only in 2000 and 1929 did the measure exceed 30, versus an average since 1872 of 16.1. As of January 17 this year, the number was 33.2. Following the historic lessons of CAPE overvaluations, a gradual return to something nearer 20 on the scale would equate to annual real returns on stocks in the US of under 1%.
But there are good reasons to downplay this alarming signal. Using trailing 10 years of earnings mean we are still using depressed earnings from the 2007-09 period; as those fall out over the next two years, the CAPE will fall back towards its average. Shiller himself has said that the CAPE is useful over the longer term but very poor at predicting tops inside 3 years.
For those of us still needing reasons to doubt the durability of the long rise in equities since 2009, lower savings rates in the US in recent years have robbed the future of potential consumption and would drag on actual economic growth in coming quarters. Then there is the reduction in liquidity that comes from a shrinking Federal Reserve balance sheet. This may be a tree falling in a forest, if the Fed gets its way, but the unprecedented current combination of a low unemployment rate, fiscal stimulus, rising stock and commodity markets and clearly nascent wage pressures warrant a very close look now in the US and elsewhere.
The contradiction between these messages of caution and the apparently explosive mix of fiscal easing with still easy monetary policy—all of it underwritten by the endlessly cited ‘synchronous global expansion’ which now has taken shape—is a tough one for investors to reconcile. When in the past have we had such a flammable and bullish combination? With so much fuel, why would anyone want to miss out on further gains which seem so inevitable?
History has a way of providing the answers to these questions, usually from some unanticipated quarter—geopolitical conflict, emerging market crisis, wobbly financial architecture. While the first is always a contender, the latter two don’t appear obvious candidates today. Of course, they never did in the past either.