Equities tick higher

Dec 01, 2017
Although the long equity bull market looks set to continue for a little while longer, is an equity bear market on the horizon?

With international equity markets reaching new high after new high, is an equity bear market around the corner? There are certainly plenty of grounds for nervousness. Having hit a low of 666.78 in March 2009, the benchmark US stock index (the S&P 500) is now comfortably above 2,500.

In addition, US equity valuation levels are elevated. The cyclically-adjusted-price-earnings ratio (CAPE) overcomes a key shortcoming of the traditional P/E, which is that cyclically-elevated earnings can make even inflated values look reasonable. It does this by comparing today’s price to average inflation-adjusted earnings over the previous decade. The result thus compares equity values to a measure of earnings which, being based on a 10-year average, gives us a “through the cycle” value for earnings. At the end of November, the CAPE ratio for US stocks was 30.8. Since 1881, that value has been exceeded twice: in the immediate run-up to the 1929 Great Crash and in the years around the climax of the TMT (technology, media and telco) bubble in 2000.

The elevated level of the CAPE ratio has in the past been a harbinger of meagre equity returns. When Mebane T. Faber wrote his paper, A Quantitative Approach to Tactical Asset Allocation, he studied the impact of CAPE values on subsequent real annual equity returns over the following decade for the years 1881-2011. He reported that when CAPE values exceeded 30 in the past – as they do now – subsequent equity returns for the following decade averaged less than zero. In short, US equities are valued at expensive levels which, in the past, have generated dismal returns over succeeding years.

Timing signals

While valuation metrics may give a good indication of returns in the medium- to long-term, they traditionally work poorly as timing signals. Just because something is expensive today doesn’t mean that it can’t become even more expensive tomorrow. And there are several reasons to believe that this equity bull market may continue for a little while longer.

Global money supply continues to grow faster than industrial output. That indicates that the monetary environment is supportive for assets values to continue increasing, as the recent $400 million sale of Leonardo da Vinci’s Salvator Mundi signals. And investors have not demonstrated the frenzied enthusiasm which typically occurs at bull-market tops. Citibank maintains a Bear Market Checklist to warn of an impending reversal in equity markets. This is a list of 18 global factors. In 2000, 17 suggested unsustainable froth. In 2007, 13 factors were telling investors to sell. The subsequent bear markets wiped more than 50% off global share prices in each instance. What is the story today?

My main concern

According to Robert Buckland, Citi’s global equity strategist, “Right now, only three of our 18 factors are indicating typical bull market excess”. He observed that global equity inflows do not yet look especially frothy. Neither does investor sentiment, according to Citi’s US Panic/Euphoria index. And while global M&A, IPOs and capex are picking up, they remain modest compared with the gains seen in equity indices.

The thing that concerns me most about global equity values today is the turn in the central bank cycle from loosening monetary policy to tightening. The US and the UK have already experienced interest rates rises. The key reason why interest rates remain so low this long into an economic recovery is that inflation remains so subdued. If inflation was to pick up, the cycle of central bank tightening would accelerate. It was central bank tightening which eventually caused rising equity markets to reverse in 2000 and in 2007.

Today, inflation remains subdued and anticipated rate rises follow a shallow and unthreatening trajectory. So it looks as if the long equity bull market is set to continue, but be careful – with valuations this elevated, being long on equities may be the equivalent of picking up nickels and dimes in front of a steamroller.

Cormac Lucey is an economic commentator and lecturer at Chartered Accountants Ireland.