Permabulls, popular pundits, and pump-and-dumpers argue that the U.S. market is "cheap," implying that every sell-off, including the high-volume rout we saw last week, is yet another buying opportunity. Martin Wolf, the thoughtful and well-regarded columnist for the Financial Times, suggests otherwise in "Equities Look Overvalued, But Where Is the Turning Point?"
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. At a time when asset markets are generally buoyant and risk premiums low, the need for a reminder of riskiness is valuable. It is far better, as natives of San Francisco must know, to suffer a series of mini-earthquakes than a long period of calm, followed by a huge one. Similarly, euphoria in markets is dangerous. 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: last week, Standard & Poor's 500 index fell by 4.4 per cent and the MSCI world index by 4.5 per cent. 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.
The chart [not included here], taken from data prepared by London-based Smithers & Co, shows the actual and the cyclically adjusted price-earnings ratio of the Standard & Poor's composite index since 1881. The cyclically adjusted measure follows the method of Professor Robert Shiller of Yale university: it is the ratio of stock prices to the moving average of the previous 10 years' earnings, deflated by the consumer price index. The picture shows that the 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. The chart shows real earnings per share and the average of the previous 10 years' real earnings per share. 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. But real earnings also rose by 170 per cent between December 1991 and September 2000, before collapsing in the ensuing months: in March 2002 real earnings of the companies in the index were only 19 per cent higher than at the previous trough, over a decade before.
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. The question one has to ask is whether they will be sustained or fall back again, as they have done in the past.
Over the past 125 years, real earnings of companies in the index have grown at only 1.5 per cent a year - lower than in the economy as a whole, because the index is always underweight in new and dynamic companies. Over the past quarter century real earnings have grown at an annual rate of 3 per cent. The annual growth of 25 per cent seen since the most recent trough will not last. On past experience, it is far more likely to turn negative.
If we are to assess when that might happen, we have to recognize that the buoyancy of corporate profitability is just one of several extraordinary features of the world economy. Here are a few others: dynamic and now widely shared growth; low real interest rates on risk-free securities; low inflation-risk and credit-risk premiums and so low nominal interest rates; huge current account "imbalances"; and low inflation, in spite of big rises in prices of commodities, especially oil.
This combination explains many phenomena in financial markets. The borrowing by private equity funds to buy corporate assets is just one....
The dangers ahead look big. One is that markets will overreach themselves, so generating a destabilizing 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.
While Mr. Wolf is hesitant to place his bet, many of us do not have that luxury. In my view, there are ample signs that the turning point has already been seen.