There is a great deal of concern surrounding the outlook for American equity markets. The markets are up nearly 200 per cent from their low of 666 in March 2009, and many credible and serious market observers are expecting a big bear market to hit US equities anytime now. The bears are making the argument that valuations are very high in the US on any valuation measure using normalised earnings and profit margins. Current price-to-earnings (P/E) ratios look reasonable since the denominator is based on peak profit margins, which are unlikely to be sustained.
The bears point to worrying signs in terms of sentiment. Margin debt is at an all-time high; investment advisor bullishness is very elevated; and we see bubble-like behaviour in initial public offerings and mergers for new technology companies. Flows into equities have also started to pick up. The bears also make the point that we continue to live in a very artificial environment, driven by super-easy US Federal Reserve policy. As Fed policy normalises - the path and timing for which are now clear - we will see market disruption. One cannot normalise a hyper-stimulative policy environment without market casualties.
It is notoriously difficult to time bear markets, but it is interesting to see how the US markets look on some simple indicators. The US markets remain the most important, and any significant decline there will have consequences for equity markets globally.
In an attempt to understand the vulnerability of the US equity markets, the most important variables to assess are monetary conditions. Tight money conditions are a clear negative for equities. Monetary tightening leads to an economic slowdown and has a consequent impact on corporate earnings. High interest rates will reduce the relative attractiveness of equities as an asset class and also disproportionately reduce the value of any long-duration asset such as equities (through a higher discount rate). Slowing money supply growth (a normal consequence of a tight monetary policy stance) will reduce the surplus liquidity that can flow into financial assets from the real economy.
How should one measure monetary conditions? Which measures have some predictive power vis-a vis equities? BCA has done some research on this topic and has come up with a few key variables.
The slope of the yield curve is a simple and effective way to judge the monetary stance; a flat to inverted slope implies tight policy. The spread between the 10-year bond yield and the three-month Treasury bill is probably the best way to measure the yield curve. If this spread is negative or zero, that is normally a good leading indicator of market vulnerability. Another equally effective measure would be to look at the gap between five-year bond yields and three-year bonds.
The level of real short-term interest rates is another effective tool to assess monetary conditions from an equity market perspective. In general, real short-term rates will need to be strongly positive before the onset of any bear market. Though an imprecise indicator, real short rates above two per cent seem to have the ability to cause market damage.
Another tool investors may use to judge monetary conditions is a type of Marshallian K construct: comparing the growth of some form of money supply (like M2) to nominal gross domestic product (GDP). The logic is that whenever money supply growth lags nominal GDP, liquidity will be sucked out of financial assets for real economy use. The reverse flow from the real economy into financial assets occurs when M2 is growing faster than nominal GDP. As BCA points out, the gap between growth in M2 and in nominal GDP turned negative before almost every bear market prior to 1980. Though this signal has been less effective in recent years, it is still something to keep track of.
Currently, none of the three monetary indicators mentioned above shows any signs of impending market stress. The yield curve is positive, real short rates are negative, and money supply growth continues to exceed nominal GDP. There is nothing on the monetary side that should worry market participants. Yes, the Fed has begun normalising monetary policy, but raising rates from very low levels when economic growth is improving should not trigger a bear market. Market volatility and disruption, yes - but bear market, no.
Valuation is the other obvious indicator that judges a market's vulnerability to a bear phase. Valuation indicators, whether they are simple P/E multiples or even the cyclically adjusted P/E, have very little use for timing equity bear markets. Valuation overshoots can persist for long periods of time. Valuations are, however, useful in determining prospective returns. Buying a market when P/E ratios are high will generally deliver lower 10-year returns than buying when P/Es are low. There is also a loose relationship between the extent of overvaluation and the severity of the subsequent bear phase. While equity markets in the US are no longer cheap, they are not at an extreme either. Current trailing P/E ratios are within 10 per cent of long-term averages. Stocks also look very cheap if one uses any interest rate-based valuation tool, which reflects the extent of overvaluation in fixed-income markets. As discussed, valuation is not useful for timing - but apart from that, except for some technology and biotechnology subsectors, broad market valuation does not seem to be at such an extreme as to cause worry.
Technical indicators - such as sentiment, breadth and momentum - can be important in trying to understand market vulnerability and are useful at market turning points. Current technical readings are mixed - the market is above its 200-day moving average, but sentiment seems elevated with investment advisor bullishness and margin debt at an extreme. However, given the amount of discussion that is taking place on bubble-like conditions in financial markets, it does not seem that we are in the midst of euphoria. Nor are equity market flows strong enough.
US equity markets will eventually have a significant bear market. All markets are eventually cyclical, but there seems to be no reason to feel that it is imminent. A shock independent of monetary policy can induce a market correction, as can a serious economic recession - but the first is not forecastable and the second seems unlikely in the short term. Most economists expect the US economy to actually accelerate from here, not fall into another recession. A significant decline in corporate earnings can also be another trigger. However, absent a recession, despite the calls for regression to the mean in terms of profit margins, one cannot see how earnings in the US can decline enough to trigger a bear market. Recent corporate earnings have been weak, but they are not declining.
If the US equity markets hold, that will hopefully provide an enabling backdrop for equity markets across the world.
The writer is at Amansa Capital
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
