Now that the military battle in Iraq is over, my sense is that equity markets want to go up. But I don’t believe that this is the start of a new bull market. It is just the eye of the storm of the secular bear market. The bounce will eventually die down and the bear market will reassert itself. We have not seen the lows yet.
The market will ignore valuations for now. These remain stretched. I estimate the S&P500 to be selling on 18 to 19 times this year’s earnings. On a multiple of dividends, US equities are absurdly expensive – and dividends count these days. I trust dividend multiples more than P/E ratios because the manifold definitions of profit floating around throw up too many conflicting messages. But the Nasdaq is outperforming the broader indices. That means two things are clear: the market wants to go up and it doesn’t give a toss about valuations for now.
Geopolitics will look good for a while too. The US is likely to draw back from military confrontation to test the diplomatic dividend of its victory in Iraq on Syria, Iran and in negotiations with North Korea. This will be a momentary peace but the market won’t know that for a while.
Ultimately, for the neo-conservative policy of unilaterally decreed regime change in rogue states to be achieved – if persuasion fails – the tool of pre-emptive strikes is too costly for the US economy to bear. But for now geopolitical risk has vanished from the market. And the entire street is keen to get back to an appreciation of the daily dose of company results that don’t look too bad.
Why does this rally not herald a new bull market? US corporate quarterly results show that profit margins are improving and that cost control is superlative. But top-line sales are much more iffy. For the moment, the market, having had so much bad news for so long, will like signs of slow, grinding improvement in corporate health.
The picture of better margins, good cost control and little top-line growth is in accord with the thesis that margins are being clawed back by cutting wages and jobs. High labour productivity gains make this possible. The flipside of the productivity miracle, though, is that it may well boost long-term potential growth but also reduces it by cutting consumer income in a weak cycle.
A job-destruction programme
It does so because the economy stops creating jobs. It destroys them. US employment was down 0.2% year on year in March. So the consumer, stacked high with debt, has less money to spend and saves more of it. The trend to higher thrift is already under way.
The US is the world’s most efficient marketplace. That goes for both the demand and supply sides of the economic income statement. But US structural problems lurk in the balance sheet not in the income statement of the country. It is all about bubbles.
Bubbles make the world go round. Alas, we are running out of them. After the Japanese bubble economy burst there was the Asian miracle economy bubble. After that we had the US IT and dot-com bubbles.
Bubbles create their own liquidity because bankers will lend into them. That raises money multipliers, liquidity and real demand. But the driver is in the mind – the perceived rarity and potential of an asset doomed to surfeit – not in the money. Nevertheless, bubbles do boost real demand: Japan did grow like crazy while misallocating its capital and inflating its assets. Asia wasted limitless, costless capital on phallic towers and golf course capitalism but real demand boomed all the while.
The world would not have grown at all in recent years without bubbles. Right now, a few are still supporting the global economy. The US consumer is sitting atop the world’s most significant bubble (housing and concomitant household debt), without which the world would be in depression. It may still get there.
Inexorably, the consumer’s ability to service this debt is being eroded by corporate America making profits by paying less for labour.
My guess is that the US adjustment from profligacy to thrift will take three to five years. That promises lousy top-line growth for corporations. But there is no obvious replacement bubble like a super new ‘must-have’ technology. Bubbles create their own liquidity as much as liquidity creates bubbles, but the only sort of liquidity that is connected to rising real demand and asset prices is broad money and credit, not central bank money. An exception is when central banks force base money onto banks that can’t lend. That will create a bubble in government liabilities if it’s the only way banks can earn a return on the base money they are forced to accept.
So liquidity is the result as much as the cause of asset bubbles. It will fade away when those that remain burst. I don’t see where the next bubble is developing to save our financial souls. So enjoy the rally, but be ready to sell into it some 15% to 20% up in equity markets from now.
