You know when you are in a bull market when bad news simply gets shrugged aside and even the most indifferent events get greeted exuberantly. Nine months ago the result of the Italian election, which drags the future of the Eurozone back into question, would have induced a market panic. This time round the world’s equity markets barely blinked before resuming their attempt to breach the all–time peak they reached shortly before the onset of the global banking crisis.
Something similar happened last Friday when Congress failed to agree how to avoid the package of mandatory spending cuts known as the sequester. Republicans and Democrats came up with these cuts in 2011 because they were so potentially damaging that it was unthinkable any party could possibly contemplate them allowing them to come into force. Or so they thought. On March 1st the deadline for avoiding the sequester passed without resolution. Wall Street barely twitched.
Like most of the world’s stock markets, which tend to follow its lead, Wall Street has been on a tear ever since it learnt to stop worrying about tiresome European news and started focusing instead on the tangible signs of recovery in its own economy. Since last July, when Mario Draghi, the head of the European Central Bank, vowed to do “whatever it takes” to save the euro, the US stock market has moved in one direction only, buoyed by confirmation that its free-falling housing market, a key driver of its economy, has finally taken a decisive turn for the better. Wall Street has not experienced a correction of more than 10% since the middle of 2011.
And the rally could go on. Market strategists at the big investment banks have been strenuously pushing the case for shares since the New Year. Some even make the case for a “market meltup”, meaning a market in which at one stage prices simply start to run away under nothing more than their own momentum. Few big investment institutions can afford to be left behind in a rising market early in the year. The longer it goes one, the greater the pressure on them to join in, whether they buy the argument or not.
A market meltup cannot be ruled out, but it is not the most likely outcome. The longer shares press on without a significant setback, the sharper and more likely the next correction becomes. Company earnings, on which shares prices ultimately depend, are forecast to grow by around 7% this year, which is hardly spectacular, even if you believe the figures. (Which you shouldn’t: for each of the last four years consensus start-of-year earnings estimates by analysts have been reduced as the year progressed, leading to mid-year market declines).
On most traditional measures, shares as a class do not look overly attractive. In their definitive analysis of global investment returns since 1900, the London Business School professors Dimson, Marsh and Staunton conclude that current valuations point to an annualised future rate of return of 3.0-3.5% per annum after inflation. That is positive but still some way below the long term average. Neither the dividend yield, nor the price-earnings ratio, suggest a market that is obviously cheap. (Europe, because of its obvious political risks, and Japan, which is finally setting a course to fight its way out of deflation, look better bargains if valuation, rather than risk, is the primary criterion).
The two most important things that shares have going for them are that they offer a measure of protection against future inflation, which may be on its way, and what they are not, namely government bonds, whose yields have been deliberately driven down to ultra-low levels by the easy money policies of Western central banks. The long term argument for overweighting equities against government bonds in these conditions is irrefutable.
However as long as central banks continue to use the printing presses in an effort to kick the economy into action, the scope for the price of government bonds to continue defying traditional investment logic remains. It could take several years for government bonds to revert to more appropriate levels. Too many investment institutions have reasons, or excuses, to go on owning them.
And despite the relative attractions of shares as a class, stock markets face an important technical hurdle. Having more than doubled since their low point in 2009, the main US market indices are now within touching distance of their 2007 all-time highs. (1565 for the S&P 500 index and 14,164 for the Dow Jones Industrial Average). If these two indices go past these historic levels, and stay there for more than a few days, it will be a powerful signal that investors are prepared to put historic concerns aside and take the stock market higher still. The main UK market index is also closing in on its all-time high.
So although equities remain the best of an indifferent set of choices for longer term wealth preservation, I would venture that the smart money is still against the market breaking decisively out of the broad trading range that it has been in since 1998. Many old City hands nurture the suspicion that we may need one more nasty bear market before we can finally declare victory over the financial crisis. The Great Winfield, a fictional character in Adam Smith‘s classic book about the 1960s bull market The Money Game, made a point of only employing young guys under 30 to run his funds.
He rationalised it this way: “The strength of my kids is that they are too young to remember anything bad, and they are making so much money that they feel invincible”. While the economic backdrop is very different today, the majority of market participants have never lived in a world in which bond yields go up, rather than relentlessly down, and central bankers no longer have keeping the stock market above its natural level as a specific policy objective.
Nor have they ever known the miseries of stagflation, let alone a full-blown sterling crisis, which is an ominous spectre hovering over the future of the UK economy. All these risks remain. In the long run the stock market reflects the way the economy and company profits go, but for long periods it can blithely follow the path of its own self-fulfilling perceptions. This spring brokers are whistling their way to work. That is encouraging, but don’t be lulled into thinking that there won’t be further turbulence ahead. As bull markets go, this one has still to prove itself the real enduring deal.
Jonathan Davis 