A dangerous frenzy in the stockmarkets

It can hardly be a coincidence, says Randall W Forsyth in Barron’s, that advertisements for testosterone supplements are often shown on financial cable channels.

High testosterone levels instil the ‘winner’s effect’, “a useful evolutionary tendency toward confidence for those heading into battle, as well as for successful traders”.

But it also “eventually leads to hubris… with the predictable results seen in 2008”. The bullishness in the US stock-market is looking increasingly irrational.

Last week, the Chinese internet giant, Alibaba, the biggest initial public offering (IPO) or flotation in US history, soared on its first day of trading, jumping to a price/earnings ratio of 61.

Regardless of Alibaba’s impressive growth potential, this looks very high, especially considering its dodgy corporate governance. Shareholder rights are so weak that the Hong Kong stockmarket would not allow the company to list there.

The US market is in the midst of a boom in flotations not seen since the dotcom bubble burst, says James Mackintosh in the FT. An IPO frenzy is a sign that “investors are overexcited”.

What’s more, adds Mackintosh, “leveraged loans… are not just flashing red but have a wailing siren and a man walking in front waving a flag”. These are loans for private-equity groups buying companies that already have a lot of debt.

More than a third of such loans this year were worth more than six times the target company’s earnings. That’s only slightly below the multiple seen at the peak of the credit bubble in 2007.

Moreover, a record 60% of loans are currently ‘covenant-light’, with less creditor protection than usual.

There are several other signs of irrational exuberance. Margin debt, whereby investors borrow money to play the stockmarket, has reached record levels. The share buyback boom, which has artificially inflated earnings per share, looks set to run out of steam, as we noted last week.

Finally, valuations are high. The market’s forward price/earnings ratio of just under 16 is close to record levels. A far more reliable gauge, the cyclically adjusted price earnings ratio, looks extremely high (see next story).

In short, the market is looking extremely stretched – just as the US Federal Reserve is set to reverse the liquidity spree of recent years by hiking interest rates.

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