Quantitative easing has done financial markets the power of good, but less so the real economy. Since the depths of the post-Lehman despair in the fourth quarter of 2008, multiple-expansion has flattered investor returns as all the central bank liquidity seeped its way into equity and bond markets. Despite profit margins being at record levels in the US, only 60% of the rise in the S&P500 price index can be justified by underlying earnings growth. In Europe and Japan the role played by expanding price-to-earnings ratios has been even more dramatic.
Feast and famine
A host of long-range valuation measures are beginning to suggest that the last seven years of feast have run their course. With central banks remaining cautious on policy normalization, this may not automatically evolve into seven years of famine. But the probability of a period of lacklustre returns is high. And the risk of a more substantial correction is growing.Valuation is rarely a reliable short-term guide to equity market performance. There are just too many momentum players out there waiting to jump on the next hot tip. You only have to look at the Chinese equity market to understand that. Nevertheless, in the longer term, forward returns tend to be higher if you buy when the market is cheap and disappointing if you buy rich. Investors ignore valuation at their peril.
The better-regarded measures are those that have a long demonstrable track record. Several of these are beginning to flash red. Tobin’s Q is the market value of equity and debt divided by the replacement cost of assets. Equity Q is the market value of equity alone (market cap) divided by the replacement cost of assets less the market value of debt (equivalent to shareholders’ equity on a replacement-cost basis).
In practice, these two measures tell you much the same thing. So splicing the two together provides a series, which is both long-run and timely. Whenever the broad market is valued above the replacement cost of corporate assets (the ratio is above 1.0), it generates a strong sell signal; concomitantly, anything below around 0.4 is a buy signal. Its other key attribute is that at the turning point of the cycle it is strongly mean-reverting. Q is currently at 1.1, the third-highest reading of the last 100 years and into overvalued territory.
Also, the Shiller P/E ratio, which values the equity market in comparison to average real earnings over the last 10 years, is now at 27x compared to a long-run average of 16.6x. In the last 140 years this valuation has only ever been exceeded three times – in 1929, in 1997 to 2000 and briefly (though only marginally) in 2007.Excitement
When the US equity market broke at the peak of those cycles, the subsequent declines were rather – how shall we put it? – exciting: -85% between 1929 and 1932; -42% between 2000 and 2002; and -51% between 2007 and 2009.Finally, broadening the analysis to a range of equity markets globally shows that the breadth of overvaluation is exceptionally wide – having only been exceeded in 2007. And we’re about 21 months into overvalued territory. The obvious catalyst for a sell-off – Fed normalization during the second half of the year – is staring us in the face too. The main caveats are the experience of the late-1990s dot.com boom and the 1925 to 1929 bubble where valuations pushed far above those prevailing today.
All in all, the stars are beginning to align for some rather nasty price action in the months ahead. It is time to batten down the hatches.The risks to this call will centre principally on timing. Any delay in Fed tightening beyond the second half of 2015, supported by the asset substitution effect of sovereign QE and the ongoing hunt for yield, could push equity markets higher for longer – despite their stretched valuations.