Expensive markets

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Friday, March 23, 2018

Expensive markets

Peter Stanyer writes:

'Stock markets are trading at historically high valuations, and although bond yields in the US have picked up as the Fed has scaled back quantitative easing, 10 year US Treasury yields are still under 3%, having been around 1.5% in mid-2016, and corresponding gilt yields are still stuck well below 2%'

Peter Stanyer is co-author with Professor Stephen Satchell of The Economist Guide to Investment Strategy, 4th edition, Profile Books, 2018.  Peter is an independent economic consultant to the Financial Planning Corporation LLP.  The views expressed are his own personal views, and do not constitute advice to buy, sell or hold any investment.

Investors are getting used to such yields, and need to remind themselves that interest rates remain unusually low.  These sustained low rates go a long way toward explaining the high level of stock market valuations.  More recently, stock market volatility has picked up from unusually low levels; overall corporate profitability is high; the global economy (if not the UK economy) is growing comfortably and inflation is low.

At the same time, much business – energy generation and use, and vehicle design to name two – is planning for further radical transformation, while in other sectors such as retail and real estate rapid change is proceeding apace.

These elements help explain why the stock market might reasonably be more expensive than usual.  They do not tell us how much more expensive.

Investors naturally worry about expensive markets, but most also know that it is perilously difficult to time markets.  Apparently expensive markets provide a welcome opportunity to make sure risk taking is broadly appropriate.  It is never smart to hold off being prudent so as to enjoy the party for a bit longer.  This might be profitable, but just because you might get away with it does not mean it would be sensible.

The temptation to stay taking high risk a bit longer is best countered by reminding ourselves that £1,000 of losses are reckoned to hurt twice as much as much as we enjoy £1,000 of gains.  There is regret in missing gains, but it is less painful than incurring the equivalent losses.

For those who have already accumulated significant savings, markets which may be expensive provide a good opportunity to recheck that risk taking is roughly where it should be.  They do not provide a sufficient reason to delay or stop regular long term saving.

Politics can always destabilize the best laid plans, but a more immediate risk to short term market developments may be the danger that central banks misjudge the process of gradually exiting from the extraordinary low interest rates and quantitative easing of the post-crisis years.

The Federal Reserve is much further along this road than either the Bank of England or the European Central Bank, though this does not reduce the risks of markets being upset by apparent policy mistakes.  Global stock markets will be most sensitive to apparent mistakes in US monetary policy.

Meanwhile the Federal Reserve has a new chairman, nominated by President Trump.  Jerome Powell, a governor of the Fed since 2011, is now leading efforts to juggle the counterbalancing pressures of maintaining low unemployment and low inflation.  Mostly, these concerns are about the short term.  Over the next five or ten years, the key will be whether current stock market valuations are broadly justifiable.

Value investors are by nature loudest in expressing concerns about overvalued stock markets, but they inevitably judge today’s markets by historic norms.  The challenge for their analysis (as some recognise) is that the anchor that interest rates provide to valuations has been cut adrift by the persistence of unprecedented low interest rates, which might justify unusually high valuations.

At the same time, it is a characteristic mistake of value investors to underestimate the ability of US Inc. to reinvent itself and its technology, and global business with it.  This was the experience with the emergence of internet and software companies in the 1990s.

In the last decade or more, internet shopping has been disrupting retail business and investment in shopping malls.  Two thirds of US households and one third of UK households are now reported to be Amazon Prime subscribers.  That represents 90 million households in the US with next-day delivery and downloading of music, movies and books.

The prospect of driverless electric cars is also likely to disrupt large swathes of both manufacturing and the oil and petroleum sector, while big data and bio-tech may do the same for pharmaceuticals and healthcare.  Globally, the careers of hundreds of millions seem likely to be upended by relentless technological change; while investors need to ensure they don’t get left behind by the changing patterns of global business.

The restless shape of the equity market has always been a characteristic of equity investing: at the start of the twentieth century railroad stocks accounted for over 60% of the US stock market by value before declining to less than 1%.

Those with particularly long memories will recall the October 1987 stock market crash, which seemed to come from nowhere, other than a gradual increase in bond yields.  This 23% decline in one day in the US stock market now appears as a blip from the perspective of a long term investor, but it would have been enormously expensive for those whose investments were inappropriately allocated or leveraged and which then had to be adjusted after markets fell.

For steady long term investors, a more appropriate lesson might be the risk of being out of the stock market far too early.

This echoes a comment made in August 2002 by Alan Greenspan, then chairman of the US Federal Reserve.  Looking back on the unwinding of the late 1990s equity market boom, which he had anticipated by publicly voicing concerns about “irrational exuberance” over three years prior to the market peak in early 2000, at a level 80% higher than when he gave his warning, Greenspan said:

‘As events evolved, we recognised that, despite our suspicions, it was very difficult to definitively identify a bubble until after the fact – that is, when its bursting confirmed its existence.’

Greenspan’s comments should encourage us all to be modest about our ability to call markets successfully.