Don’t believe the hype
By Neil Unmack and Agnes T. Crane
When some of the most influential financial thinkers of our time failed to call one of the biggest bubbles since the Great Depression before it burst, a little skepticism about the recent run-up in stocks is a healthy antidote to the cheerleading that typically accompanies big gains.
Given the enormous size of the last bubble, the current round of inflation in financial markets perhaps should be called by another name — maybe “bubblette” would better suit the times.
The hallmarks, though, are similar: Access to cheap credit helps re-inflate depressed prices, but eventually the explanations for extended gains start looking flimsy. Stocks started entering that territory in August when many pointed to better-than-expected earnings to justify the surge in prices that have taken major gauges to their best levels for the year.
The price-to-earnings ratio for the S&P 500 currently stands around 26.5 based on operating earnings for 12 months through June. That’s well above the historical average of 19.26, according to S&P senior index analyst Howard Silverblatt.
To get back to normal, the economic recovery will have to be powerful enough for earnings to meet more optimistic expectations. The price-earnings ratio for the FTSE 100 is still just below its historic average, but nevertheless stands at its highest since July 2004.
There are good reasons to rejoice about the recovery in stocks — for one, they make last year’s losses less painful. But there are also plenty of reasons to think the market will pull back in the near term, and to foresee a rude awakening if the much talked-about V-shaped recovery fails to deliver.
– The consumer is key. Still buried under a mountain of debt and daunted by the prospect of joblessness, consumers aren’t likely to return to their old spending habits. More saving and less spending means low growth, excess capacity, and falling prices, all of which are bad news for equities.
– Unprecedented fiscal and monetary stimulus are distorting reality. While some markets have returned to their levels before Lehman Brothers collapsed a year ago, much of the stimulus behind the recovery is still in place to keep money flowing into even some of the riskier asset classes, such as high-yield debt and stocks.
Start taking the various props away, which will begin to happen this autumn, and investors’ appetite for risk will diminish.
– Ridiculously low government bond rates and rock bottom interest rates in the developed world have pushed investors to look elsewhere for yield. But this can’t last forever. Eventually central banks will raise rates, while increased borrowing needs still lurk as a potential flash point for bond vigilantes who want to be compensated for the risk of future inflation.
– Funding markets, while much improved, still aren’t working properly. While many companies have been able to refinance their short-term debt, borrowers in real estate markets are still facing a funding void left by the collapse of the shadow banking system.
High-yield companies in the United States and Europe face far higher borrowing costs, and must also refinance or pay down a wall of debt falling due in coming years. Commercial real estate, in particular, faces daunting maturing debt.
Unless more sources of alternative funding can be found, the result will be higher borrowing costs, more defaults and bank losses, and more corporate failures. Companies in general will focus on keeping their creditors sweet, rather than doling out cash to shareholders.
Stock buybacks have sunk to their lowest level since 1998, when Standard & Poor’s first started tracking the data.
– Unemployment rates are expected to stay high. Economists view unemployment data as a lagging indicator, but this time may be different. A persistently high unemployment rate will likely keep anxiety high among consumers who stretched themselves thin during the boom years. Even if it steadies, the unemployment rate could keep consumers on the straight and narrow.
– Follow the smart money. Insiders, such as company management, are selling at the highest rate since before the crisis kicked off in 2007. Sure, the sellers may have their own personal reasons for dumping stock, or they may know what is going on better than anyone.
Some of these arguments were equally true in March — since then the FTSE has gained 45 percent. Investors who avoided stocks for sound fundamental reasons back then have been dealt a cruel hand by the recent upswing.
The cheap liquidity and confidence that drove the rally may well persist for some time, or even carry the market higher if third-quarter earnings beat expectations.
Still, investors who missed the equity market party should be doubly wary of joining in now that the good times may be over.