Surprisingly Strong Words from Martin Wolf

As you may well know, Martin Wolf is the Financial Times’ award winning economics editor and their lead economics commentator. He is thoughtful, measured, articulate, and takes far greater pains than many of his peers not to overstate his data.

So it was stunning to see at the top of the home page of the FT’s website, a link to Wolf’s Wednesday piece, “How long will the markets be able to defy gravity?” The actual title to the article was only marginally less grim, “Equities look overvalued, but where is the turning point?

It’s not that I disagree with Wolf. Quite the contrary. I have argued that the whistling-in-the-dark confidence of a lot of American financial commentators is overdone. Worrisome events are still playing themselves out – the Bank of Japan intervening to keep the carry trade from unwinding further, the subprime debacle, interest rates on the bonds of investment banks spiking upwards due to losses on their CDO holdings. Moreover, the fundamental outlook for the US economy is poor. The current high level of corporate earnings appears unsustainable, and despite brave talk, the housing market looks to be getting worse rather than better. But I have toned down my views because (let’s face it) the regulators and the market participants are trying to talk the market back up. Everyone wants this genie back in the bottle. It is possible they will succeed, not this month, but over the course of the next two or three months.

Wolf, by contrast, does something more intelligent, more difficult, and in the end more valuable than trying to foresee, even in a general way, the trajectory of the markets. He instead takes a long view of valuation and global economic conditions, and argues, persuasively, that equities are still considerably overvalued. But he is not about to call a turn (he views last week as a mere blip) but discusses some of the factors, most notably the weak conditions in the US housing market, that might precipitate a change.

Is the market turbulence of the last week telling us something or is it no more than “a tale told by an idiot, full of sound and fury, signifying nothing”? Some analysts are prepared not only to explain day-to-day movements in markets, but to predict them. I am neither clever enough for the former, nor rash enough for the latter. I am prepared, however, to make four statements: first, a period of market volatility is welcome; second, core equity markets do look overvalued; third, that this does not appear to be the case is due to the extraordinary condition of the world economy; finally, the big question is how long those conditions will endure.

Any long period of market stability encourages speculation. Taken to excess, such risk-taking, particularly when fuelled by huge amounts of borrowing, can create significant instability. At a time when asset markets are generally buoyant and risk premiums low, the need for a reminder of riskiness is valuable. It is far better, as natives of San Francisco must know, to suffer a series of mini-earthquakes than a long period of calm, followed by a huge one. Similarly, euphoria in markets is dangerous. From time to time it needs to be punctured, before bubbles reach the proportions seen in Japanese markets in 1990 and US markets in 2000.

The corrections we have seen in important stock markets are modest: last week, Standard & Poor’s 500 index fell by 4.4 per cent and the MSCI world index by 4.5 per cent. But could this be the start of something bigger? One way of addressing this question is to examine the valuation of the most important market of all, that of the US.

The chart, taken from data prepared by London-based Smithers & Co, shows the actual and the cyclically adjusted price-earnings ratio of the Standard & Poor’s composite index since 1881. The cyclically adjusted measure follows the method of Professor Robert Shiller of Yale university: it is the ratio of stock prices to the moving average of the previous 10 years’ earnings, deflated by the consumer price index. The picture shows that the actual p/e ratio is now very close to its long-run mean of just over 15. The most recent cyclically adjusted p/e ratio, however, is 26.5, or about two-thirds above its long-run average. It is not as astronomically high as in 2000, but it is very high, by historical standards.

What is going on? The answer is that the US – and, indeed, most of the world – has experienced an enormous surge in corporate earnings. The chart shows real earnings per share and the average of the previous 10 years’ real earnings per share. What emerges is the cyclicality of earnings. What also emerges is the scale of the recent surge: in real terms earnings rose by 192 per cent between March 2002 and December 2006. But real earnings also rose by 170 per cent between December 1991 and September 2000, before collapsing in the ensuing months: in March 2002 real earnings of the companies in the index were only 19 per cent higher than at the previous trough, over a decade before.

It is always a mistake to confuse a cycle with a trend. In the case of corporate earnings, it is worse than a mistake, it is a huge blunder. The intense cyclicality of corporate earnings is the most important reason why the unadjusted p/e ratio is a worthless indicator of value. The question one has to ask is whether they will be sustained or fall back again, as they have done in the past.

Over the past 125 years, real earnings of companies in the index have grown at only 1.5 per cent a year – lower than in the economy as
a whole, because the index is always underweight in new and dynamic companies. Over the past quarter century real earnings have grown at an annual rate of 3 per cent. The annual growth of 25 per cent seen since the most recent trough will not last. On past experience, it is far more likely to turn negative.

If we are to assess when that might happen, we have to recognise that the buoyancy of corporate profitability is just one of several extraordinary features of the world economy. Here are a few others: dynamic and now widely shared growth; low real interest rates on risk-free securities; low inflation-risk and credit-risk premiums and so low nominal interest rates; huge current account “imbalances”; and low inflation, in spite of big rises in prices of commodities, especially oil.

This combination explains many phenomena in financial markets. The borrowing by private equity funds to buy corporate assets is just one.

Some of what we see is also surprising. This is particularly true of the association of rapid global economic growth and high profitability with low real interest rates and little concern about inflation. A world such as this is one in which one would have expected high real interest rates and worries about inflation, not the opposite.

So what is going on? Several answers emerge: monetary policy credibility, the great achievement of central banks over the past quarter of a century; globalisation of world markets in goods, services and capital; the incorporation of China into the world economy; the almost fixed Chinese exchange rate and consequent downward pressure on dollar prices of manufacturers; the shift of world income to two groups of high savers – the east Asians and, more recently, the oil exporters, and the consequent emergence of a huge savings surplus in these countries; the role of governments as accumulators of US dollar liabilities, especially treasury bonds; the role of the US as borrower and spender of last resort; and the rapid growth of US productivity.

All this together has generated the conditions for stable economic growth. But how long will the happy times last?

The dangers ahead look big. One is that markets will overreach themselves, so generating a destabilising correction. Another is a reduction in excess savings outside the US and a tightening of world interest rates. Another is a slowdown in US productivity growth. Yet another is a shift in global monetary conditions that threatens the soaring profitability of the US financial sector. But the biggest risk is that the end of the US property boom will persuade US households to tighten their belts at last, thereby ending the US role as the world’s big spender before the big savers are prepared to spend in turn.

We can be confident that profit growth will not continue at recent rates. But a sharp reversal, though possible, may not be imminent either. The economic risks are evident and the market does look expensive. But I would not dare to forecast a turning point. Forecasting is for far cleverer and braver people than I am.

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