Stockmarket investors are more optimistic than the fundamentals warrant
EQUITY markets finished 2013 with a bang, with the S&P 500 index delivering a return to investors of more than 30%, once dividends are included. And investors’ optimism appeared to be borne out by trends in the American economy, the world’s largest, as third-quarter growth figures were revised higher on December 20th to show an annualised gain of 4.1%.
Even so, there is something slightly odd about this rosy picture. Economic growth is good for the stockmarket because a healthy economy should boost profits. But the data show that profit growth slowed significantly in the third quarter. Total corporate profits in America grew by $US39.2 billion over the three months to September, compared with a $US66.8 billion rise in the second quarter; domestic profits rose by $US12.7 billion, down from $US37.8 billion.
As a result, the big gains of 2013 were caused by investors re-rating the equity markets (giving shares a higher valuation) rather than because of the profit fundamentals. Total profits for S&P 500 companies in 2013 are likely to have risen by only 7.7%, a long way short of the gains in the index.
Equity investors are always forward-looking, of course, so perhaps their optimism was caused by their views on profits in 2014. That sounds plausible in theory, but the facts are rather different; analysts spent December revising down their profit forecasts.
A slowdown in profit growth would hardly be surprising, given that profits are at their highest as a proportion of American GDP since the second world war. But that points to another oddity. On the best long-term measure, the cyclically-adjusted price-earnings ratio (which averages profits over 10 years), American equities trade on a multiple of 25.4, according to Professor Robert Shiller of Yale University, well above the historic average.
Why would a higher-than-average p/e ratio be justified? For individual stocks, the answer is clear: rapidly-growing companies trade on a high multiple of current profits because their future profits are expected to grow strongly. But American companies do not fit the template. They are trading on a high multiple at a time when profits are already historically high and growth appears to be slowing.
The most common explanation for this discrepancy is that monetary policy is driving the equity market. Holding down both short-term rates and long-term bond yields forces investors out of cash and bonds and into the stockmarket. In 2013 fixed-income mutual funds suffered their first annual outflow since 2004.
The only period when the stockmarket faltered in 2013 was during the summer, when the Federal Reserve talked of reducing the scale of its monetary support. By December, when the Fed did actually announce the tapering of its asset purchases, the markets were braced for the bad news. The scale of tapering was also quite modest and the Fed, along with other central banks, made it clear that short-term rates will remain low in 2014.
Nevertheless, this only creates another puzzle. Central banks have been pulling out all the stops in monetary-policy terms; not just in the form of quantitative easing but in the low level of interest rates. In the first three centuries of its existence, which saw deflation, depression and world wars, the Bank of England never felt the need to push interest rates as low as they are now. That suggests central bankers are very worried about the economic prospects for their countries. But investors seem convinced that economies can recover and that central banks will keep rates low; either the former are wrong in their optimism or the latter’s pessimism is overdone.
This dichotomy suggests there is scope for some shocks in 2014: perhaps economic growth will disappoint or central banks may signal that their monetary support will be withdrawn more rapidly than investors currently hope. The equity markets may have got ahead of themselves a bit last year.
There is also a threat from another direction. Wall Street seems to have had a much better recovery than Main Street. Asset prices have responded vigorously while real wages have been squeezed. Inequality has been widening (see Free exchange). It is hardly surprising that voters have become discontented, with a surge in support for the populist right in Europe and plenty of partisan bickering in Washington. The combination of an angry electorate and nervous governments may lead to unpredictable policy measures–and an atmosphere that is hardly helpful to either business or investor confidence.
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