It has been a very good year to be a bull. Despite the US economy ostensibly experiencing the worst economic catastrophe since the Great Depression, with headline unemployment at 10% (and real unemployment almost double that), share markets across the world have rebounded with incredible haste. The Economist reported that “the MSCI world index of global share prices is more than 70% higher than its low in March 2009. That’s largely thanks to interest rates of 1% or less in America, Japan, Britain and the euro zone, which have persuaded investors to take their money out of cash and to buy risky assets”.
The rebounding US market is all the more astonishing when compared to 1982, the period that many claim to have been the end of the last significant economic slump. Data compiled by Haver Analytics and Gluskin Sheff (and reported in the Financial Review) paints a very somber image.
In 1982, around the time Business Week was proclaiming “the death of equities”, the US economy was slowly emerging from a decade-long nadir. Interest rates had been increased to 18% as Fed Reserve chief Paul Volcker courageously sought to defeat the menace of inflation. In 2010, courtesy of Ben Bernanke, US interest rates are practically zero. In 1982, the Fed could use lower interest rates to reduce the cost of capital and spur investment — now, that cost can only rise. The monetary base of the United States in 1982 was $US170 billion — following rampant quantitative easing, the US now has a monetary base of $US2.2 trillion. Meanwhile, household debt to personal-disposable income increased from 62% in 1982 to 123% now.
In the past 18 months, the US government has tried to inflate away its woes, printing money to buy bonds that it used to pay off its massive deficits. At the same time, private debt has also increased as American institutions borrow to speculate on assets such as shares and commodities. Meanwhile, on Main Street, the news is less positive, recent reports indicate that almost 40 million Americans have been forced to resort to relying on food stamps.
While not a perfect measure, the average price earnings multiple of the S&P500 is currently 20 — in 1982, the ratio was eight. The market is effectively factoring in a substantial increase in earnings. If corporate profits remain steady or drop, the US share market will fall substantially. (And like it or not, most world markets, especially the Australian market, remains well correlated with the United States. It may be flawed, but it is still an icon). As The Economist noted in a separate article, “valuations [based on the cyclically adjusted price-earnings ratio, which averages profits over the previous 10 years] are pretty high by historical standards; Smithers and Co, a firm of consultants reckons they are 50% above their long-term average. Even now, after a dismal decade for shares, Wall Street is offering a dividend yield of just over 2%, compared with a long-term average of 4.5%.”
MIT and former IMF chief economist Simon Jackson was even more pessimistic, especially of the financial sector, telling Tech Ticker that “the biggest problem is that the ‘too big to fail’ institutions have gotten bigger during the crisis because of all the bail-outs … and they feel invulnerable, so they are already going out and taking reckless risks.”
As for the view that markets always recover, such optimism is worthy more of fairytale than real life. As The Economist explained, “investors tempted to take comfort from the fact that asset prices are still below their peaks would do well to remember that they may yet fall back a very long way. The Japanese stock market still trades at a quarter of the high it reached 20 years ago. The NASDAQ trades at half the level it reached during dotcom mania. Today the prices of many assets are being held up by unsustainable fiscal and monetary stimulus. Something has to give.”
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