Finance & economics | Buttonwood

Same old song

Market conditions bear a worrying resemblance to those of 2007

HAD Rip Van Winkle fallen asleep in early 2007 and woken up today, he might not have realised there had ever been a financial crisis. Credit spreads are low, house prices are rising and takeovers are booming. America’s two main stockmarket indices, the Dow and the S&P 500, keep hitting new highs. Volatility is also extremely low (see chart).

Of course, the awakening Rip might get a bit of shock if he examined the interest rate on his savings account. Rates have been close to zero in the rich world for five years now. Over that period, investors have learned that it pays to take more risk.

The general view as 2014 began was that equities would continue to do well (Wall Street enjoyed a stonking 2013, with the S&P 500 gaining 30%). This view has been undented by a volley of bad news, including a fall in America’s GDP in the first quarter (revised this week to 2.9% at an annualised rate), renewed East-West tensions over Ukraine and turmoil in Iraq, which has pushed the oil price higher. There are also signs that the pace of Europe’s recovery is slackening. The purchasing managers’ surveys for the euro zone fell by more than expected in June while the IFO survey of German business confidence dropped to a six-month low.

The latest Bank of America Merrill Lynch poll of institutional investors found that a net 48% were overweight equities, even though a net 15% felt that stocks were overvalued. This apparent contradiction is easily explained since an even bigger share of investors felt that bonds were overvalued: equities must seem the lesser of two evils. But investors also thought that bonds were overvalued at the start of the year, and yet yields have fallen since then.

Another factor propping up the stockmarket has been the repurchase of shares. In America companies have been buying back their shares at an annualised rate of $400 billion, or 2.5% of GDP, according to Andrew Smithers, an economic consultant. Buy-backs enhance earnings per share, thereby boosting the value of executive options.

There is a widespread but fallacious belief that the repurchases are the result of improved corporate balance-sheets. Some companies, such as Apple, are awash with cash. But Andrew Lapthorne of Société Générale calculates that, in aggregate, net debt (ie, after subtracting cash) in America’s corporate sector is a record $2.3 trillion, having risen by 14% over the past year. The ratio of long-term debt to total assets is close to its 2009 peak.

At the same time, there have been signs of weakness in profits. Figures from the Bureau for Economic Analysis (BEA) show that profits from current production went down by $198 billion in the first quarter, while net cashflow fell by $120 billion. Although some of the decline might be the result of the economy’s weather-related dip, it is worth noting that profits from operations abroad shrank by $26 billion.

A fall in American profits would hardly be surprising, given that they have been close to a post-war record (as a proportion of GDP) for a while. But analysts have generally ignored the BEA’s numbers and are still expecting profits to rise this year; the consensus forecast for S&P 500 companies says they will go up by 9%. Higher profits are needed to justify current equity valuations; the cyclically adjusted price-earnings ratio (which averages profits over ten years) is 25.6, well above the historic average of 16.5, according to Robert Shiller of Yale University.

None of this may dent investors’ confidence as long as they believe that central banks will remain supportive. The recent statement from the Federal Reserve was perceived to be reassuring: although the monthly pace of asset purchases will slow (“tapering”, as it is known in the jargon), the Fed is in no hurry to raise rates. The European Central Bank eased policy in its latest statement and the Bank of Japan is still increasing the money supply. Only the Bank of England is breaking from the pack, hinting that rates might rise later this year.

But the central dilemma remains. Either central banks are right to be worried about the economy, and to keep rates low, in which case profits will eventually disappoint. Or central banks are wrong, and they will be forced to raise rates more rapidly than the markets expect. Both outcomes seem likely to bring more uncertainty and thus more volatility. The speculative euphoria of 2007 may be missing. But until the outlook becomes clear, few investors want to give up on what has been a winning strategy of owning equities. Investors are reluctant bulls; there seems no alternative.

Economist.com/blogs/buttonwood

This article appeared in the Finance & economics section of the print edition under the headline "Same old song"

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