Turning Point? Confusing a Cycle with a Trend

More on the recent share market movements in the Financial Times yesterday, this time by Martin Wolf. A more serious and ecumenical take.

Equities look overvalued, but where is the turning point?
By Martin Wolf

Is the market turbulence of the last week telling us something or is it no more than “a tale told by an idiot, full of sound and fury, signifying nothing”? Some analysts are prepared not only to explain day-to-day movements in markets, but to predict them. I am neither clever enough for the former, nor rash enough for the latter. I am prepared, however, to make four statements: first, a period of market volatility is welcome; second, core equity markets do look overvalued; third, that this does not appear to be the case is due to the extraordinary condition of the world economy; finally, the big question is how long those conditions will endure.

Any long period of market stability encourages speculation. Taken to excess, such risk-taking, particularly when fuelled by huge amounts of borrowing, can create significant instability… From time to time it needs to be punctured, before bubbles reach the proportions seen in Japanese markets in 1990 and US markets in 2000.

The corrections we have seen in important stock markets are modest… But could this be the start of something bigger? One way of addressing this question is to examine the valuation of the most important market of all, that of the US… (T)he actual p/e ratio is now very close to its long-run mean of just over 15. The most recent cyclically adjusted p/e ratio, however, is 26.5, or about two-thirds above its long-run average. It is not as astronomically high as in 2000, but it is very high, by historical standards.

What is going on? The answer is that the US – and, indeed, most of the world – has experienced an enormous surge in corporate earnings… What emerges is the cyclicality of earnings. What also emerges is the scale of the recent surge: in real terms earnings rose by 192 per cent between March 2002 and December 2006…

It is always a mistake to confuse a cycle with a trend. In the case of corporate earnings, it is worse than a mistake, it is a huge blunder. The intense cyclicality of corporate earnings is the most important reason why the unadjusted p/e ratio is a worthless indicator of value…

He went on to opine on the real major trends that are sweeping across the global economic landscape.

(W)hat is going on? Several answers emerge: monetary policy credibility, the great achievement of central banks over the past quarter of a century; globalisation of world markets in goods, services and capital; the incorporation of China into the world economy; the almost fixed Chinese exchange rate and consequent downward pressure on dollar prices of manufacturers; the shift of world income to two groups of high savers – the east Asians and, more recently, the oil exporters, and the consequent emergence of a huge savings surplus in these countries; the role of governments as accumulators of US dollar liabilities, especially treasury bonds; the role of the US as borrower and spender of last resort; and the rapid growth of US productivity.

All this together has generated the conditions for stable economic growth. But how long will the happy times last?

The dangers ahead look big. One is that markets will overreach themselves, so generating a destabilising correction. Another is a reduction in excess savings outside the US and a tightening of world interest rates. Another is a slowdown in US productivity growth. Yet another is a shift in global monetary conditions that threatens the soaring profitability of the US financial sector. But the biggest risk is that the end of the US property boom will persuade US households to tighten their belts at last, thereby ending the US role as the world’s big spender before the big savers are prepared to spend in turn.

We can be confident that profit growth will not continue at recent rates. But a sharp reversal, though possible, may not be imminent either. The economic risks are evident and the market does look expensive. But I would not dare to forecast a turning point. Forecasting is for far cleverer and braver people than I am.

Good read.

Elanor