Does the market exuberance make sense?
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There are two interesting phenomenon going on in the world. One is that stock markets are reaching for new highs in many countries in the West and second, economic cycle indicators are looking up in many parts of the world, including in China.
It is tempting to look for neat and black or white answers. But, they are unlikely to be useful. Clearly, one year ago, concerns over China loomed large. Now, they have receded. China’s economy remains fragile. But, it is not front-page news. It may not mean anything in the long run. After all, an enormously big credit surge had helped paper over the cracks again. The only way that the fault lines could be exposed in a highly repressed society—financially or otherwise—was through capital outflows. That was happening. But the Chinese government had come down hard on it. So, we need to wait to see if the leaks erupt anywhere else— even in non-economic ways.
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In the US, consumer confidence is up. The economy is operating near full employment. Purchasing managers’ indices are reaching new highs. Inflation indicators are ticking up and small businesses are feeling confident. Their complaint is that not enough skilled workers are available. Small business confidence indicator jumped big in December and has stayed there in January. Even the stealth deregulation that has been pursued by the new administration has been enough to buoy their hopes. It is a bit of a surprise—and an eye-opener—to see how the small businesses are responding to the change in regime and the hope it has brought.
This raises questions on the hypothesis of “secular stagnation” championed by Lawrence H. Summers. How much of the secular stagnation was due to the secular forces and how much of it was due to the cyclical forces of a misguided presidency and misguided monetary policy? Indeed, it is worth re-examining if zero or negative rates reinforced pessimism and delayed a revival of capital spending in the US.
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In other words, is the stock market correct in discounting a renewed surge in growth, incredible as it may sound? Unfortunately, it is possible to get carried away with this train of thought but one has to hold back because the feeling of renewed business optimism is not seen in the US alone. Even in the Eurozone, where political uncertainties remain to be sorted out, cyclical economic indicators such as purchasing managers’ indices and inflation indicators are up. In Japan, suicide rates are down and childbirth rates are rising. Is it all a delayed reaction to the years of loose monetary policy and the end of the drag from deleveraging? Unfortunately, facts do not support the appealing argument that the world is done with deleveraging and hence is now perking up. The truth is that, post-2008, the global economy never really deleveraged.
Based on statistics available from the Bank for International Settlements, it is possible to figure out who deleveraged and who did not. To a large extent, households in advanced economies reduced their debt. But corporations releveraged. In emerging economies, all sectors gorged on debt. Suffice to say that the non-financial sector (corporations, households) in G-20 countries had added 29% more debt in US dollar terms since the end of 2008 up to the middle of 2016. Hence, it is not as though releveraging is a recent phenomenon to justify the rejuvenation of an economic cycle that is already long in the tooth. All told, one has to reluctantly conclude that the optimism about the global cycle does not seem very rational.
That brings us to the exuberance in the stock market. In the US, the S&P 500 stock index is trading at 30 times cyclically adjusted (10-year average) real earnings. In short-hand, it is known as Shiller PE (price-to-earnings) since Robert Shiller came up with it and he maintains an Excel file which gives us all the raw data and the calculations. On the last two occasions the Shiller PE crossed 30, the market crashed shortly thereafter and in the next instance, it went up by 80% before it collapsed. Smarter people than yours truly point out that markets always know better than mere mortals. Perhaps.
But the Bank for International Settlements reminded us in its Annual Report for 2016 that “there is no guarantee that over any period of time the joint behaviour of central banks, governments and market participants will result in market interest rates that are set at the right level”. It was with reference to the sovereign bond yields that were too low for the level of debt that many governments are carrying. It is true of stock markets too where non-price sensitive sovereign investors and algorithmic investors dominate. We do not really have a market.
The next argument is that the 30 times Shiller PE is justified given much lower interest rates now than on the previous two occasions. One, even when interest rates were around 3% in the period between 1946-65, the Shiller PE ratio averaged under 16. Second, one must consider lower nominal gross domestic product growth rates now. Third, the current trailing 12-month PE is just under 27 times.
According to Goldman Sachs’ research, when the 10-year treasury yield hovered between 2-3%, the trailing PE ratio averaged a little over 13 times. So, I am not able to justify the market euphoria now. Not for the first time and not for the last time. Yet, I will be careful. Cassandra was proved right, eventually.
V. Anantha Nageswaran is the co-author of Economics Of Derivatives and Can India Grow?
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Read Anantha’s previous Mint columns here