Heading up? Or heading for a fall?

Fri 11 May 2018

By Brian Dennehy

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Market commentary


The Times rang to chat about the outlook for the US stock market – I think they were writing a reasonably chilled piece, but wanted thoughts on the CAPE (cyclically adjusted price earnings) ratio in particular. Here are my thoughts – not so much chilled, more chilling.

up and down

In 2018 the cyclically adjusted price earnings ratio (CAPE) – a common measure of the over or under valuation of the US stock market – has exceeded 32, which is even higher (slightly) than 1929, and twice as high as its long-term average.

To return to its long-term average the US stock market would have to halve.

The naysayers will tell you the indicator is bust as it has shown the market as expensive for a number of years.  Unfortunately, this means valuation-sceptics become even more over-confident that the market is in fine fettle.  
It is these people who will fuel the final hurrah and be the cannon fodder for the next bear market – whenever it comes.

Is it just CAPE telling us the market is over-valued?

No. There are many more indicators flashing bright red although the over-confident will find cause to ignore these too.

For example, the favourite Buffett indicator (market cap-to-GDP) has not just eclipsed the dotcom mania but also the Japanese peak of December 1989 – a 28-year bear market followed the latter and the Japanese market remains more than 50% below its peak.  Don’t ignore the possibility just because it’s scary – build that into your investment plan!

Bullish investors might point to the good earnings season as evidence of the strength of the economy.  But the recent positive earnings results are, counter intuitively, a negative indicator of market returns. 

For example, after quarters of 20%+ earnings growth subsequent returns have tended to be way below average (2.6% annualised).

Don’t forget that “emergency” action taken by central banks following the Lehmans crisis has allowed companies to massage their earnings per share and dividends for years.  For example, cheap debt makes it easy and inexpensive to pile up debt to buy back shares.  This pumps up the share price but isn’t investment in the company’s future.  If anything, it’s borrowing from the future to juice returns in the present.

And the squeeze is coming with interest rates going up and quantitative easing (QE) changing to quantitative tightening (QT).

This shouldn't get you down.  All you need to do is ensure that you've dealt with this possibility in your investment plan.  This will be specific to each individual investor.  Make sure your plan does what you need it to.

Because sadly, as Lord Overstone said: “no warning can save people determined to grow suddenly rich”.



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