Andrew Smithers, as he notes in his latest World Market Update, has been saying for ages now that the equity markets are overvalued – but probably going up. In other words, while on long term valuation measures equities are priced to deliver below-average returns over the medium term, in the near term with momentum and other factors, principally central bank monetary stimulus, egging them on, they can easily go on rising for quite some time. (For what it is worth, that has been my basic stance for most of this year too: markets are far more volatile than the fundamental value changes). But is that period now due for pause?
While we are not yet calling an end to this, we see it drawing to a close. The two key supports for the US stock market are corporate buying of equities and quantitative easing (“QE”). The former is threatened by current fiscal plans and the latter by the need to taper QE should unemployment continue to fall. If the Federal budget is finalised as currently indicated then a decline in corporate cash flow seems highly likely and corporate buying, which has fallen recently, is likely to fall further.
If the current budget is not modified, the economy is likely to slow and this would probably cause the Fed to taper its tapering. If the budget is modified, the impact on corporate cash flow would be reduced but the chances of Fed tapering would be increased. Equities have been pushed up by the combination of corporate buying and quantitative easing. It is possible but unlikely that both will remain in place during 2014.
We all know that equity markets rarely move in a straight line. 2013 has been a great year, with the main US indices driving through their pervious all-time highs early in the year and heading for full year gains of 20%-25%, with almost all the gain coming from positive rerating (higher multiples) rather than from earnings growth. The mid-year “tapering” wobble seems to have passed. Equity fund flows have been running at their strongest since 2004, with bonds on course to produce a negative return for the year as a whole. A correction would be helpful, though I somewhat doubt we will see it before the second quarter of next year.