Not my words. But a neat description, by one of the most perceptive commentators around, of the US stock market – the driving force behind last month’s record highs in global share indices.
Since the start of February, though, stock markets around the world have sold off. The FTSE 100, for example, lost all of 2017’s gains in just a fortnight.
So – as a rally gets underway – have the price falls finished yet? Not in my book. Here’s why the next bear market could be just getting started…
Not new news
American stocks have been very pricey for a long while. So let’s put it into context.
The Shiller P/E, otherwise known as the Cyclically-Adjusted PE ratio (CAPE), measures the US equity market’s present valuation of average inflation-adjusted earnings over the last decade. And despite February’s sell-off, the CAPE is still hovering around its second-most expensive level ever (the highest was the dot.com bubble at the start of the millennium – enough said!)
Very scary, you might think. But professional investors don’t seem to be fretting too much about this. They’re continuing to invest in the markets.
Remember, though, that the people who run equity funds are generally optimistic.
For most, the job means buying shares and trying to get their prices up. Being bearish doesn’t tend to pay off. As the cliché says, turkeys don’t vote for Christmas.
That’s why it’s worth listening to James Montier. Sure, he works in the fund management business: he’s the European strategist at asset manager GMO. But he addresses the risks that most money managers prefer to overlook. And his latest analysis starts with today’s opening line: that US stocks are “obscenely overvalued”.
To be fair, I’m doing the fund management profession a slight disservice here.
It’s not completely ignoring the form book.
Indeed, the net percentage of asset allocators who reckon shares are overvalued is now higher than the dot.com years. It’s just that all these shareholders can’t help themselves. Regardless of valuation, they keep ploughing more cash into equities.
Fully invested bears
“This gives rise to the existence of that strangest of creatures: the fully-invested bear”, says Montier. “The most common rationale for such a cognitively-dissonant stance is ‘fear of missing out (FOMO) on the upside’. As I think Seth Klarman (the legendary value investor) pointed out long ago, this isn’tfear at all, but rather greed”.
In fact, Montier shares a view I’ve previously expressed, namely that we’re seeing ‘greater fool theory’ in action. This is where cynical buyers know they’re not investing at fair prices but plan to dump their holdings before the bubble bursts onto even more gullible players.
“Obviously, this is impossible”, he says. “Like a game of musical chairs played at a child’s birthday party, when the chairs are increasingly rare, the competition for them gets fiercer. Crowded exits don’t end well – inevitably some are crushed in the stampede.I prefer to leave the party early in the knowledge that I can walk away with ease.”
Bad news from bonds too
That’s clear enough. Stock prices may be rallying from their early-February falls but they still look very vulnerable to another major sell-off.
While we can’t know when this will take place, it may not be far away.
There’s growing bad news from one of the triggers of the February sell-off.
US 10-year Treasury yields are a global benchmark for long-term interest rates. When these rise, bonds become more attractive to investors and equities lose their appeal. And Treasury yields keep on climbing. They’re now up to a four-year high of around 2.9% from just over 2% in early-September last year.
By the often-sluggish standards of the bond market, that’s some move!
What’s been the reason?
For one thing, US inflation is going up faster than expected. The country’s consumer price index grew by 0.5% in January against economists’ forecasts of a 0.3% rise, reports the BBC. And earlier this month another report showed accelerating US wage growth. As a result, concerns have increased that the US Fed will need to hike interest rates earlier than previously anticipated.
Further, there’s Trump’s tax planning (if that’s the right word!)
There’s been lots of upbeat talk about this in the media. But look behind the numbers and there are plenty of reasons to fret.
America’s Committee for a Responsible Federal Budget has just said that the latest US budget “relies on extremely optimistic and unrealistic economic growth assumptions and numerous gimmicks…deficits and debt would likely continue to rise unsustainably under the President’s proposals”.
Not the sort of language that long-term lenders to the US government – in other words, bond investors – like to see.
Over to Societe Generale’s Albert Edwards, Montier’s former colleague, on the US budget: “this is probably the singularly most irresponsible macro-stimulus seen in US history”, he says. “To say it is ill-timed and ill-judged would be a massive understatement. It will rapidly accelerate the end of the economic cycle.”
“In the next, not so distant, US recession, the general government deficit will soar way beyond the 13% the OECD say was the peak for 2009. A ruinous fiscal deficit in excess of 15% of GDP will be Trump’s legacy.”
In other words, the States will end up borrowing more each year than ever before. So how will this hit the equity market further?
“Trillion dollar deficits are just over the horizon, which will cause US government debt as a share of GDP to rise in the next several years to over 100%”, says George Magnus, former UBS Chief Economist and now at the China Centre in Oxford.
“Markets fear that significant unfunded government borrowing – especially when the economy is doing well – will cause the Federal Reserve to carry on raising interest rates, in turn pushing bond yields higher. On current trends, this cyclical shift will eventually, maybe in 2019, puncture the stock market, corporate profits, and most likely the economy.”
If all the above plays out – and it’s hard to see how it can be avoided – what price Wall Street then? US stocks, along with equities around the world, look set to face a very uncomfortable time. Don’t be fooled by the rally. The next bear market could be just getting started. And I reckon this could be before 2019.
Cash and – in particular – gold are likely to become more and more appealing alternatives to stocks and bonds. The time to prepare your portfolio is right now.