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2013-03-07 07:49:55
Mar 6th 2013, 18:17 by P.C.
ONE more milestone has been passed on the road to recovery. On March 5th the
Dow Jones Industrial Average closed at 14,253.77, a new high, finally
surpassing the level reached in October 2007, just as the subprime-mortgage
crisis really took hold. (The S&P 500, a more broadly based and soundly
constructed index, stayed just shy of its record high.)
Wall Street is not alone. Stockmarkets in the developed world have been in
fairly buoyant mood since the start of the year with the MSCI World Index
rising by 5% in the first two months of 2013, and the Japanese market gaining
13.5%. Emerging markets, in contrast, have been flat.
It is tempting to attribute the strength of the Dow to optimism about the
American economy. Tempting, but wrong. Studies have shown almost no correlation
between GDP growth and equity returns. Indeed, the Shanghai stockmarket trades
at less than half its 2007 peak, even though the Chinese economy has performed
much more strongly than that of America since then. This rally in the Dow has
been accompanied by the weakest GDP growth of all the bull markets since the
second world war.
The main factors behind the current surge seem to be twofold. The first is a
degree of confidence that some tail risks have been avoided, at least for
now. The euro zone has not broken up and politicians in Washington, DC have not
brought the entire economy to a halt over tax-and-spending policies. Hurdles
remain (such as raising the debt ceiling) but investors assume a deal will be
done.
The second factor is that equities look better than the alternatives. Cash
yields are puny and central banks have made it clear that interest rates will
not rise for a while. Ten-year government bonds outside the euro-area periphery
yield 2% or less. Although there is no sign of the much-heralded great
rotation out of bonds and into equities, there are signs that investors are
putting cash in both asset classes following a long period in which equity
funds suffered withdrawals.
Some think the bull market is bound to continue as long as the central banks of
America, Britain and Japan keep buying assets. There are three guys with
cheque books which matter in the world, and they will all have hand cramps in
the coming quarters and years as they furiously accumulate trillions in
securities, was the verdict of David Zervos, a strategist at Jefferies, an
investment bank. The only safe asset, as these fiat cash and reserve
liabilities explode higher, is the one that has at least a chance of generating
positive real returns equity capital.
Can cheap money prop up share prices in the long run? Research by the London
Business School shows that low real interest rates have historically been
associated with low, not high, equity returns. Mohamed El-Erian, the chief
executive of PIMCO, a fund-management group, said recently that: For the rally
in equity markets to continue, the current phase of assisted growth, as anaemic
as the outcome is, needs to give way to genuine growth.
The stockmarket fundamentals are not that encouraging, however. Profit growth
has been slowing. In the fourth quarter of last year, earnings per share of
companies in the S&P 500 grew at an annual rate of 6%, according to Soci t G n
rale. The growth rate is expected to be just 1.2% in the first quarter of this
year, and 0.1% if financial companies are excluded. Analysts are more
optimistic about the second half of the year, but they usually are upbeat at
this point in the calendar; reality kicks in later.
The best long-term measure of value, the cyclically-adjusted price-earnings
ratio (which averages profits over ten years), is at 22.9, around 39% above its
long-term average, according to Robert Shiller of Yale University. An
alternative measure, the Q ratio, which compares shares to the replacement cost
of net assets, shows the American market as 50% overvalued, according to
Smithers & Co, a consultancy. The dividend yield on the market is 2.6%,
compared with the historical average of 4.1% (although share buy-backs partly
compensate for this shortfall).
Valuation does not often drive the market in the short term. During the dotcom
bubble investors were happy to buy shares on stratospheric multiples: the
cyclically-adjusted p/e reached 44 in late 1999. But the aftermath of that
bubble illustrated an old rule. When investors buy assets at above-average
valuations, they will suffer below-average future returns.
Given the current combination of low bond yields and high equity valuations,
Antti Ilmanen of AQR, a fund-management group, calculates that the prospective
return from a balanced American portfolio is the lowest it has been for a
century. That is not good news for American corporate-pension funds, which
still have a $479 billion deficit even after the latest rally, according to
Mercer, an actuarial group. For the moment, though, the bulls are happy to
leave that worry for another day.