US stocks look expensive. You won’t find many people who will argue with that. A recent survey from Bank of America Merrill Lynch showed 80% of investors agreeing.
And why wouldn’t they? The S&P 500 has risen by nearly 80% in the last five years, despite earnings per share (which should be the driver of share prices) rising at only 9%.
It is now trading on a trailing price/earnings ratio of 25 times and a cyclically adjusted price/earnings ratio (otherwise known as a Shiller p/e) of 29 times. That’s scarily close to double the long-term average.
The US isn’t alone in its overvaluation: the FTSE 100 and the FTSE 250 have both hit new highs in the last few weeks. The FTSE 100 is now on a silly p/e of 30 times and Capital Economics puts the UK market as a whole on an average p/e of 21 times. The long-term average is under 14 times. Our Shiller p/e isn’t quite as nuts as the US’s (a mere 18 times). But it isn’t exactly screaming “buy me now” either.
We also have our own UK-specific indicator of animal sprits to keep an eye on here — investment trust discounts. The more confident investors get (overconfidence is a danger signal in markets) the narrower the discounts become. So the fact that they are knocking around their 15-year peaks should not be considered a good thing if you are a long-term investor.
The same goes for pretty much every valuation indicator there is. Run your eye down a list of developed market p/e ratios and you will see that almost all of them are a good 30% over their long-term averages, the worst offenders outside the US being Norway, Spain, the Netherlands, Finland and the UK. The only market on the list that looks even vaguely respectable is Japan, which is trading just below its long term p/e (see my article from last week for more).
Think about that. Then think about the falls in the US market this week. Add them up and odds are you will start to think that Tuesday (when the S&P 500 fell more than 1% for the first time in 109 days) might just have marked the beginning of the end of the great post-crisis bull market (now the third best and the third longest on record in the US). After all, the biggest cause — perhaps the only cause — of stockmarket crashes is overpriced stockmarkets.
However, as Capital Economics points out, markets don’t just collapse of their own accord. They need a trigger, an actual change or, given how flighty investors can be, just a perceived change. Without one, a 1% move in a market after going on eight years of continuous upward momentum is neither here nor there.
So what makes a trigger? Recessions do the trick. So do political disasters, fast rising interest rates and odd black swan events (the Long-Term Capital Management crisis of 1998 being a classic of the genre). Do we have any of these things here? I can’t comment on black swans, but we might end up with interest rates rising rather faster than most expect. In the UK, inflation is firmly back over 2% and beginning to look well established.
The price rises are pretty much across the board and there is no way that either the rise in the minimum wage or the currency effects of the post-referendum fall in the pound have worked their way through the system yet. In any normal environment this would mean rates heading for 4%.
I can’t imagine that many members of the Monetary Policy Committee can think it is OK to have rates at 0.25% and inflation pushing 3% for long, particularly if we see more numbers like February’s retail sales (up 1.4% against a consensus forecast of 0.4%).
That said, it’s also worth remembering that we aren’t in normal times (or rates would never have fallen to 0.25% in the first place). So interest rates moving to what ordinary people might think of as “the right level” is far from a given. No immediate trigger there.
We might see some political disappointments. The impressive rally in the US market since Trump’s election has been predicated on expectations of the implementation of lovely-sounding deregulation, tax cutting and tax amnesty policies, all of which might have the effect of boosting US corporate profits, making any valuations based on profits look rather better and (fingers very crossed for this one) kicking off a new investment cycle.
How’s this going? So far, so just about OK. Detail is still sketchy and it is perfectly reasonable to worry that Trump’s attempts to re-reform Obama’s healthcare reform might be long, drawn out, boring and very distracting. If they are, deregulation and tax reform will end up falling down the list.
Still, there is no reason to give up on it all yet. There are several signs that Trump would be happy to give up on health (letting it implode all by itself, perhaps) and move straight on to tax reform. He might even have lined it up so early in his programme of reform so as to be able to abandon it early.
Elsewhere, there is less to worry about politically than there was. In the UK a Scottish referendum is off the table for now and Europe’s elections look like they are going to be less scary than expected. No obvious trigger there either. That leaves recession, which doesn’t look immediately likely either. If anything, growth seems to be picking up in the developed world.
So there you have it. Developed stockmarkets are horribly overpriced. But as long as nothing particularly awful happens there is no reason for that to change. You can relax a little. But perhaps only a very little.
Expensive stocks don’t stay expensive forever. When markets turn they turn fast. And as an individual investor you have a fabulous advantage over professional investors. You don’t have to be in any one market at any one time — or ever. You can let discretion be the better part of valour, sell out of the markets that are hitting bubble territory and let other people wait to see what the trigger is that brings them down. There is nothing wrong with waiting in cash, waiting in gold or at the very least shifting from expensive markets to cheapish markets. Try Japan, try Korea and perhaps try Vietnam.
- This article was first published in the Financial Times