Opinion | Straws in the wind that call for caution in financial markets4 min read . Updated: 30 Sep 2019, 09:09 PM IST
Current headwinds suggest that the next 14 months are unlikely to be a smooth ride for US stocks
The old Chinese saying, “Be sure of what you want; you may get it," has never been more apt for the Democratic Party in the US, and it is perhaps true for financial market investors too. Given that most of the mainstream media on either side of the Atlantic has lined up on one side of the “impeach Trump" proposition, it should be tempting for true contrarians to take the other side and buy on market dips. Several pieces of evidence, however, suggest that contrarians are better advised to pull in their haunches and watch from the sidelines.
To start with, profit margins in American companies had peaked several years ago. They have been declining slowly since then. Two, the gap between the growth in operating profits declared by S&P 500 companies and the growth in measures of corporate profit in National Income Accounts has widened considerably. It means that operating profits declared by companies to their shareholders are works of fiction. The last time that the gap between the two was this wide was in 1999-2000. What happened in 2000 to stock markets in America is easy to figure out. Third, the company that gave us the term “Community EBITDA" has had to postpone its initial public offering (IPO) and its chief executive officer (CEO) has had to resign. The turnaround in the fortunes of this company and the CEO have been too dramatic for the market to digest. However, the market would do well not to ignore it. Not only that, another company shelved its IPO and a third one that made its market debut recently saw its stock price close below the IPO offer price. These are important lead indicators for the broader market. As for actual leading indicators, David Rosenberg of Gluskin Sheff points out that the Organisation for Economic Co-operation and Development (OECD) leading indicator for the US peaked in April 2018. The same for Europe peaked in November 2017.
Then, there are Q ratios and the cyclically adjusted price-earnings ratio attributed to economist Robert Shiller. The Q ratio is better known as the Tobin’s Q. To oversimplify a little, it is estimated as the ratio of the market value of shares to the book value of shares. According to Andrew Smithers, a well known market commentator in the UK, as a result of revised data on US non-financial companies that the Federal Reserve has made available on 20 September 2019, the Q ratio suggests that US non-financial stocks were overvalued by 171% as of 25 September. Of course, by this measure, US non-financial stocks were even more overvalued in September 1929 and in March 2000, but that offers only small comfort.
Finally, stock selling by corporate insiders in the US is at its highest in two decades. This is so even as one adjusts insider share sales for corporate stock option grants and tax-induced sales. Usually, US corporate executives do not buy stocks when the market is cheap. They buy when it is expensive. This may appear counter-intuitive, but it makes sense. When the market is naturally cheap or when the company’s top line and bottom line are growing healthily, it does not need artificial props such as corporate stock buybacks. When both are struggling or when an individual stock and the stock market are fully priced, then executives need to pump the stock up so that their stock options are in positive territory. Of course, there are also tax-related and behavioural reasons for the executive preference of stock buybacks over paying out dividends. Those are dated explanations. The more proximate and realistic explanations are related to their own compensation. In this endeavour, they have been aided by America’s loose-for-long monetary policy. Borrowing cheaply at low interest rates to buy shares has been the easiest financial engineering trick that companies have engaged in this cycle. Hence, despite such compelling reasons and inducements to continue engaging in stock buybacks, if executives are selling stocks, it must be the case that they view business prospects dimly, or that their stocks are overpriced, or both.
America’s general government debt has gone up from around 76% of gross domestic product (GDP) in June 2009 to around 100% of GDP as of June 2019, according to data from the Bank for International Settlements. According to a report published in Financial Times on 25 September (on.ft.com/2mAbvmC), the median government debt to GDP ratio of a sample of 12 countries stood at 70%, the highest since the middle of the 19th century if one excludes war periods. If low interest rates had spurred economic growth sharply, debt ratios would not have risen so much. In fact, in the US, the economic expansion that began in June 2009 has been the weakest since World War II.
As the Democratic Party prepares to thwart the re-election bid of US President Donald Trump, the bitterness and anger quotients in US politics and society look set to scale unprecedented heights. Whatever the final denouement, the next 14 months are unlikely to be a smooth ride for US stocks, especially given other strong headwinds. For investors, not just in the US but around the world, there is still time to exercise caution and prudence.
These are the author’s personal views.
V. Anantha Nageswaran is the dean of IFMR Graduate School of Business, Krea University