Be afraid: The autumn could bring a significant correction in US equities
There are times when you should be afraid, very afraid. This might be one of them.
Two measures of US equities strike me as particularly worrying. First, the Shiller cyclically adjusted price-to-earnings ratio (Cape). Second, Tobin’s Q measure.
Cape is defined as the ratio of prices (on the S&P index) to average inflation adjusted earnings over the previous 10 years. The current Cape stands at just over 27, compared with a long-term mean of just under 17 – i.e. it’s 59 per cent above the historic average! Since 1881, the current value of the CAPE has only been surpassed in three periods: 1929, 1999 and 2007. Obviously, in these three instances, what followed was a crash.
The sources of a very high ratio aren’t difficult to find, based on the QE led surge in liquidity and solid earnings growth in recent years. We shouldn’t be surprised that the QE surge in liquidity found a home in equities. Those of a more sanguine disposition might also cite forward looking measures of profitability as evidence that the Cape isn’t as unbalanced as it first might appear.
Three strategic factors may also be at work. First, a reduced perception of risk. Second, the post Cold War demise of socialism. Finally, as argued by Lombard Street Research, the global glut of savings and consequent low return on capital is raising the capital value associated with a given flow of income (from capital), generating a higher Cape as a consequence.
But in this debate, one could easily counter with arguments around the potential normalisation of monetary policy, systemic risk in the Eurozone and beyond, and wider geopolitical risk as evidence that the underlying fundamentals don’t support a very high Cape. With regard to the three strategic factors above, the perception of risk could easily move upwards and any future financial crisis could reduce confidence in capitalism, and so market vulnerability is potentially high.
Historically, the record high for the Cape occurred in December 1999, when it reached 44 on the back of the technology sector boom in equities. This time around, the ratio may not have moved so high, but it is distributed much more evenly across all sectors – which is disturbing.
Tobin’s Q is essentially the total value of stocks compared to the cost of rebuilding every company from scratch. It is defined as the total price of the market divided by the replacement cost of all companies. The long-term mean for this measure is around 0.68, compared with the current value of 1.1. In other words, there is a 62 per cent deviation from the mean, the second highest figure for a century.
Very large deviations can exist for very long periods of time. Also, valuation measures are notoriously unreliable for predicting short-term market movements. On top of this, there are questions around the nature of mean reversion for measures such as the Cape, and whether a seven or 10 year moving average is appropriate. The degree of purported overvaluation can reduce with such adjustments. So we shouldn’t panic. But my sense is that the autumn could bring a significant correction in US equities.
Let’s hope it’s a correction and not a crash.