January 2, 2014 6:01 pm
2014 outlook: Market melt-up
US stocks may be overpriced and profit margins at a high but even bears say the rally has room to run
American stocks look very expensive. Are they in a bubble? The S&P 500 has gained almost two-thirds since September 2011, a period in which its companies’ earnings have risen just 18 per cent. It is easy to see why many fear the bull market has gone too far.
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But few believe that a market fall is imminent. Instead, the talk is of a potential “melt-up” in which shares build into a bubble that eventually bursts. Jeremy Grantham, founder of the GMO fund management group in Boston, says: “My guess is that the US market, especially the non-blue-chips, will work its way higher, perhaps by 20-30 per cent in the next year or, more likely, two years, with the rest of the world, including emerging market equities, covering even more ground in at least a partial catch-up. And then we will have the third in the series of serious market busts since 1999.”
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- 2014 outlook Sugar high
- Recovery will prolong US equity rally
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- Gavyn Davies Can the bull market last another year?
JOHN AUTHERS
Why is there such belief in a long-lived bull market? First, bond yields remain historically low, with 10-year Treasury bills yielding barely 3 per cent. When yields are low it is justifiable to pay a higher multiple for stocks because cheaper credit makes it easier for companies to make profits. Paying more for stocks also seems more palatable when bond yields are low.
Further, there is no evidence that investors are growing overexcited, as they usually do towards the end of a bubble. The American Association of Individual Investors’ weekly poll of its members has long been a reliable contrarian indicator. When large numbers say they are bullish it is generally a good time to sell. When the majority are bearish (the record for this indicator came in the second week of March 2009 when despair was total and the current bull market began) it is a good time to buy. Today, 47 per cent consider themselves bulls and 25 per cent bears, numbers a long way from an extreme of optimism.
However, stocks are unquestionably overpriced. Robert Shiller’s cyclically adjusted price/earnings multiple (Cape), long regarded as a reliable indicator of long-term value, is now at a level at which the market peaked before bear markets several times in the past. However, it remains below the levels it reached during true “bubbles” such as the dotcom mania. The same is true of “Tobin’s q”, which compares share prices with the total replacement value of corporate assets.
Further, profit margins are at a historic high and over time have shown a strong tendency to revert to the historic mean. The combination of high valuations being put on profits benefiting from cyclically high margins suggests markets are overvalued.
Why, then, are brokers calling for rising prices in 2014 or even a melt-up?
First, markets have their own momentum. On all previous occasions when earnings multiples have expanded this far this quickly, research by Morgan Stanley’s Adam Parker shows that they have carried on expanding for at least another year. And while the extent of US stocks’ rise since March 2009 is impressive, the duration of this rally is not unusual. Typically, bull markets carry on for longer. Also, this market has low levels of volatility and has not had a correction in a while. The approaching end of a bull market is generally marked by corrections and rising volatility.
Another reason to believe the bull market could eventually become a bubble lies in the record amounts of cash resting in money market funds, even though these funds pay negligible interest. The bull run is unlikely to peak until some of this money has found its way into stocks.
Finally, and most importantly, there is the role of monetary policy. The Federal Reserve’s programme of “quantitative easing” , in which it has bought mortgage-backed and government bonds in an attempt to force up asset values and push down yields, has had a huge impact on market sentiment.
Although the Fed said in December it would start tapering off its monthly bond purchases, it also says interest rates will stay at virtually zero until well into 2015. The S&P hit a record after the taper announcement.
Mr Grantham believes “excessive stimulus” will continue under Janet Yellen, the incoming Fed chair, and “that the path of least resistance for the market will be up”.
Hugh Hendry of London’s Eclectica Asset Management, a renowned “bear” on the stock market, takes a similar view and caused a stir late last year when he announced that he was converting to bullishness. As China slows down and in effect exports deflation to the west, he wrote in the Financial Times that there would be “a reflexive cycle that creates an unstoppable bull market: every bit of deflation coming from a frantically oversupplied China makes monetary policy looser in the west and sends asset prices higher”.
How can a “melt-up” be averted? Mr Parker of Morgan Stanley suggests that a significant correction would require fear that earnings will come in well below current projections – so the season when companies announce their earnings for the full year, which starts late in January, could be important. But with the US economy exceeding recent forecasts for growth, a serious earnings disappointment seems unlikely without a catalyst from outside the US – such as a big slowdown in China or a renewed crisis in Europe.
Failing these things, it could be left to the Fed itself to do the job by raising rates or removing stimulus faster than the market had expected.
Chris Watling of Longview Economics in London says US equity valuations are undoubtedly “full” – but are no more expensive than when Alan Greenspan, then Fed chairman, tried to talk down the stock market by warning of “irrational exuberance” in December 1996. On that occasion the bull market carried on for three more years and turned into an epic bubble before finally going into reverse.
“They’ll become more expensive,” says Mr Watling. “It’s not until we see tight money that we talk about the end of this valuation uplift in the US.”
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