The valuations of stock markets are no longer favourable. But this does not mean that the markets can no longer increase in value, because taking a look at the past shows that valuations alone are a poor market-timing tool. Overvaluations and undervaluations can persist much longer than anticipated.
A multi-year cyclical boom on the stock markets is generally brought to an end by one of the following two events:
Central banks react to rising wages and prices by increasing interest rates (restrictive monetary policy), inflation rates rise, and the result is a recession, which has a negative effect on the profits of companies over the next cycle. An inverse interest rate curve in the past has proven to be one of the more reliable indicators of an imminent recession. However, a rise in short-term interest rates does not necessarily have to lead to greater selling pressure on the stock markets. The stock market boomed from 2004 to 2006, despite interest rate rises at the short end; there was an increase in the Fed Funds from 1 per cent to 5.25 per cent with a yield on 10-year U.S. bonds of between 4 and 5 per cent. Then as now, the Fed prepared the market accordingly for the interest rate moves. A potential hazard lies in an unexpected increase in inflation in the United States, because this would cause the Fed to raise the benchmark interest rate earlier than planned, which would subsequently trigger clear reactions on the capital markets.
Heavy exaggerations on the stock markets, like those in 2000, at some point lead to sharp falls in prices (mean reversion). The valuations are currently no longer attractive. For example, the Shiller P/E ratio measured against the S&P 500 is nearly 26, which is 55 per cent higher than the historical average of 16.6. Or we can look at the ratio of market capitalisation to GDP, with reference to the U.S. stock market. The indicator is at around 123 per cent, with any reading over 115 per cent giving rise to talk of a significant overvaluation. According to Warren Buffet, this indicator is “probably the best single measure of where valuations stand at any given moment”.
It is clear that continuing price rises on the stock markets will increase the danger and the likelihood of a correction. Post-war data show that a correction of 10 per cent occurs on the stock markets each year in statistical terms. A correction of 15 per cent is to be anticipated every third year, and a fall of 20 to 25 per cent every fifth year.
The current combination of a highly expansive monetary policy, negative real interest rates, a normal (rising) interest rate curve and a moderately growing economy continues to offer favourable underlying conditions for asset price inflation. From another perspective, this combination is ideal for the formation of asset price bubbles.
Juli 2014 / MF