Is another equity bubble on the horizon?
Listening to talking heads on the big media channels one could belief the spin of “reasonably valued stocks” due to an impressive turnaround in margins & earnings of, in particular, larger corporations. But then, how long can statistical tricks do the job to keep the investors quiet?
Issue Date - 15/12/2011
Why do asset bubbles occur? Normally because of widespread denial and not due to a lack of clear indications. Thinking back to the times of the dotcom crash, the S&P 500 was trading at almost 30x trailing earnings, slightly less than double its historic mean. Back then, experts explained it with the fast penetration of Internet in all sectors of life, which led to the slight misinterpretation that cash burn rates and revenue/share price multiples are better indicators of a company´s well-being than profitability ratios. Late 2006, before the 40+% decline in US housing prices, the ratio of prices to rents was double the ‘old normal’, well reasoned again by experts due to Fannie and Freddie’s generous financing (mal)practices, governmental subsidies and, thanks to Alan Greenspan, low interest rates.
This time is different? Well, Rogoff’s and Reinhart’s publication late 2009 should have disillusioned our hopes of paradigm shifts in the avoidance of bubble/bust cycles in economies and markets. It is still not different. Why? Let’s have a closer look at the V-shape recoveries of western stock markets and if they show signs of overheating.
Filtering the most impacting factors on global stock market performances, the US consumer’s recovery and the sustainability of China’s growth path need to be top ranked.
Let’s take the US consumer’s pulse
Listening to talking heads on the big media channels, one could belief the spin of “reasonably valued stocks” due to an impressive turnaround in margins and earnings of, in particular, larger corporations. Even if a new equity bubble is arising on the horizon, signs for it are less obvious.
Now, going beyond main stream sentiment, is always worth the effort. Taking the S&P 500 current PER (Price-Earnings Ratio; trailing earnings) of 15x, we trade at levels slightly above the 14.6x of its historic mean. Reasonably priced? Applying the more realistic Shiller PER (based on average inflation-adjusted earnings from the previous 10 years), we find a fundamentally different picture. The current Shiller PER of 24x, has only been higher twice, before the Great Depression and at the peak of the dotcom boom. A statistical outlier? Let’s dig deeper. An economy with a GDP still relying on consumption at close to 70%, requires a consumer that participates in the creation of wealth. Otherwise the equation is not satisfied. The ‘real median household income’ doesn’t mince the message: no increase in over 14 years. Is the consumer at least deleveraged, after the roller-coaster real-estate ride during the last cycle? No, not even mean reverted. In fact, CoreLogic’s latest release sees more than 23% (!) of all mortgages in negative equity.
How can we expect the US consumer leading the economy out of the ‘muddle through’ period of sluggish growth, turning around the housing market and, as a consequence, justifying higher equity prices, when neither the participation rate in the US job market, nor the wages paid for work are supporting a sustainable recovery?
No wonder, why Ben Bernanke felt the pressure in August last year to announce QE II, compensating for President Obama’s lack of political capital for a second stimulus (Bush tax cut extensions late 2010 only had a marginal effect on the economy). Did the recently ended QE II at least work? Bernanke’s goal to stimulate Main Street activities expanded the central bank’s balance sheet to $2.72 trillion (or about 18% of US GDP). Inofficial M3 money supply was shrinking until spring 2011 since crisis outbreak. The Fed’s activities might not have helped the Main Street to recover (US GDP growth in Q1/11 at marginal +0.4% QoQ, compared to Germany’s +1.5% QoQ), but successfully fought deflationary pressure. We can call it consolation money. In short, the current state of the US consumer doesn’t justify the market’s assumption of a sustainable economic recovery.
Sustainable Chinese growth path
Is China the last man standing? Not so much. Since the Chinese Vice Prime Minister Li Keqiang admitted “man-made” GDP numbers that are “for reference only” (WikiLeaks, 2007 cable, published January 2011), we now officially know what to do with those numbers: to ignore them. He himself recommended to better measure the economic health via electricity consumption and similar second and third row indicators. How could we refuse the advice of a high ranked party member. Electricity consumption increased in 2010 by 14%, indicating stronger growth of the economy than the GDP numbers tell. Interestingly, the quarterly growth pattern has shown a significant slowdown during 2010. Starting with +22.7% in the first quarter, the year ended with only +5.5%.
China´s gross fixed capital formation of close to 50% end of 2010, indicate a significant overcapacity not only in real estate. Also, the rise of inflation is clearly not under control yet. Instead, quoting Simon Hunt, the National Bureau of Statistics has reduced the weighting of food prices in the CPI basket as per January 1, 2011, to lower the official inflation numbers. Statistical tricks might do the job for some time to keep the public quiet. Global investors should be warned by those red flags.
Equity investors: beware of the market’s confidence in the US consumer and the Chinese short term strength. We see emerging market indices down 20+% from their post-crisis highs. Flow of funds for Q1/11 report an outflow from EM, back to the old world’s equity markets. But also this assumption is built on sand. In short, we are bearish on global equity for the second half of 2011.