Yesterday the S&P 500 index rallied around 0.75%. That took it back to within 1.5% of its 1st March all-time high. In today’s opening quotes, shares in London are rebounding – along with the rest of the world.
Some pundits will tell you that this is a good time to invest. And that any pullback from the peak must represent a great buying opportunity.
Not in my book, it isn’t. Today I explain why not.
Within the last month I’ve shown that Warren Buffett’s favourite Wall Street gauge is providing a big cause for concern. I’ve examined how dodgy accounting has ‘improved’ corporate profits – except that it hasn’t, of course. I’ve put highly over-extended valuations under the microscope. And I’ve spotlighted how US fund managers keep piling into their country’s shares regardless of elevated price levels.
Indeed, Americans overall haven’t been as bullish as they are now about Wall Street since early-2000, according to the Conference Board. Yet as this next chart – for which many thanks to Zero Hedge – shows, that may not be a good omen either.
More than 47% of survey respondents said they expect equities to move higher in the next 12 months. That’s a jump of nearly 50% compared to recent readings. It’s also the largest share since January 2000, when optimism about stocks also peaked. Two months later, the NASDAQ index reversed into a full-blown bear market.
But let’s assume, for a moment, that the old rules don’t work anymore. And that it really is different this time.
Can stocks defy gravity?
Is it possible that US stock indices, which drive all other equity markets around the world including here in the UK, can continue to defy financial gravity?
GMO’s James Montier – an analyst whose work I’ve always found well worth reading – has just published an interesting paper on this subject. And he’s a long way from being convinced that American shares have entered a new paradigm.
“In order to make sense of today’s pricing, you need to believe in six impossible (okay, I’ll admit some of them are just very improbable as opposed to impossible) things”, he says.
These include the following assumptions. Secular stagnation (i.e. low economic expansion/inflation) will be permanent, meaning that interest rates will stay low forever. Equity values will still be set by current interest rates rather than growth rates. And financial engineering via share buybacks will continue forever, lifting EPS (as I explained last time) even though companies aren’t making any more money.
While major government bond markets are clearly priced for ongoing secular stagnation, says Montier, negative nominal interest rates are almost certainly not going to aid in any economic recovery as they’re just a tax on banks. Indeed, government policy could change the whole interest rate picture. But if “bond markets are smoking weed”, he says, “the stock market appears to be hooked on crack.”
Shiller P/E the key
Share buybacks are already lifting corporate debt to dangerous levels. And even more worrying is the warning that’s now being flashed by the Shiller P/E (price-to earnings) ratio, otherwise known as CAPE (cyclically-adjusted P/E ratio).
Compiled by Economics Nobel Prize winner Robert Shiller of Yale University, this uses 10-year average earnings rather than a single year’s EPS. It’s now above 28 times. That’s the third highest rating in history and has only been topped in 1929 and in the run-up to the TMT (technology, media, and telecom, i.e. dotcom) bubble.
So does it still feel different this time? To be honest, that’s just not a bet I’d want to make. Calling the exact top of the market is well-nigh impossible. But as my Strategic Intelligence colleague Jim Rickards notes: “bubbles can persist longer than many observers expect. However, those who heeded Shiller’s prior warnings were well served, and the same may be true again”.