FT Alphaville has reproduced some interesting statistics from the research of David Rosenberg, well known as the former chief economist for North America at Merrill Lynch with respect to valuation for the S&P 500 stock index.
According to him, the trailing price-earnings multiple (P-E multiple) of S&P 500 on operating earnings is 26 times and on reported earnings is 184 times! Certainly, even based on operating earnings, the stock index is not priced cheaply. Based on what S&P 500 companies are likely to earn next year, as forecast by analysts, the P-E multiple is 15.4 times—the highest in five years. Yes, even higher than in 2007. This is the punchline: The S&P 500 stock index is trading at more than 20% above its 200-day moving average —a condition not seen in the last 27 years.
Of course, extrapolation of the past has limitations. No two situations are similar. This time round, investors are basing their optimism on the unprecedented stimulus given by governments and central banks. That is true. Policy intervention has been huge and global. But imagine a medical parlance. A massive amount of pain is numbed with a sufficiently high dose of painkiller. Two possibilities arise: one is that painkillers do have side effects and second, if painkillers are withdrawn, what happens? Suppose the answer is that the painkillers won’t be withdrawn quickly, there would be more side effects.
We are seeing that already in exchange rate movements and in the price of gold. Regardless of the current deflationary pressure, some investors believe that such a massive fiscal spending programme coupled with the US Federal Reserve support to the mortgage market and purchase of government bonds issued by the government to support its spending programme would result in inflation some years ahead and weaken the currency. They are reacting now and the weakness is brought forward. But how long before other countries react to their currencies appreciating despite their own weak growth prospecst? How long before exchange rate skirmishes break out and then grow into currency wars? Has the stock market sufficiently priced in these risks?
Last week, the Fed released the second quarter flow of funds data for the US. This report helps us to verify the health of the balance sheets of the various entities—households, businesses (corporate and non-corporate), state, local and federal governments.
Several things stand out in this report. The overall debt level in the country relative to gross domestic product keeps rising because the federal government is borrowing massively—more than it has ever done since the 1950s. This is offsetting debt reduction by US households and businesses. Businesses? The year 2009 has seen record issue of bonds by US companies in the first nine months that has dwarfed new debt issued even in 2007. So, what is causing the level of business debt outstanding to fall? Well, businesses do not just mean corporations.
Small and medium enterprises are more important for the economy. They have not been able to obtain credit. Right up to September, the credit conditions they face have remained tight and they have been getting tighter. So much for the systemic importance of banks. They have been paring back their loans. Without expanding assets, how are they making profits? Flexible accounting rules and practices, under-provisioning for fast rising non-current assets and trading for their own account have been the drivers of profitability.
Consequently, it appears likely that the contraction in debt owed by businesses would have continued even in the third quarter. Equally, if not more important, is that debt owed by households has been dropping for the last four quarters. If so, this would be the first time that both sets of private entities would be shrinking their balance sheets whereas the government’s is exploding.
Now, the shrinking of private sector balance sheets is desirable for long-term sustainability of the US economy. But it has not been good for stock market performance in the past. Certainly, it will not deliver the kind of growth rates that US stock prices currently discount. In the past, total returns to investors were helped by dividends, but they are paltry now. The golden years for the US were the 1990s when government debt shrank, household debt growth remained stable at low levels and the business sector borrowed and invested. That explains how the technology boom started and later morphed into a bubble.
It is possible that stocks keep climbing. As someone reminded me recently, financial markets exist to make most participants humble. I have had more than my fair share, of course! Nonetheless, facts and our analysis suggest that investors, betting on further rise in asset prices, should be aware of the risks and know how to limit their fallout. When the lights go out, there would be a stampede to the exit. One could be left behind.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at firstname.lastname@example.org