Summary: Despite a positive mood in the American market, some troubling conditions remain. I am worried that the market appears overvalued when analysed using the cyclically adjusted price-earnings ratio. Housing figures have been mixed, after I expected they would be consistently strong. The quality of earnings and the dysfunctional democracy in the US are also concerning, while geopolitical turbulence is becoming less important to markets.
Key take-out: I still believe the rest of this year will be good for the economy and the market, but some worrying factors could change this.
Key beneficiaries: General investors. Category: Economics and investment strategy.
The Standard & Poor’s 500 finally broke above 2000, but has now fallen (hopefully temporarily) somewhat below that level. Alibaba has had a successful initial public offering, with the stock closing 38% above its offering price on its first day of trading. Animal spirits still prevail, but there is concern that the biggest initial public offering ever may have sapped capital from the rest of the market. Federal Reserve Chair Janet Yellen has indicated that monetary policy will remain accommodative “for a considerable time” even though the bond-buying program of the last several years ends this month, and this suggests that the first increase in short-term rates will be later rather than sooner. The United States economy grew more than 4% in the second quarter after a dismal first and it now looks like second half real growth may trend toward 3%. Scotland voted to remain a part of the United Kingdom. Investors’ outlook reflects these favorable conditions; most surveys reveal an optimistic view.
Against this background, however, there are a number of troubling conditions which could change the positive mood. I still believe the rest of the year will be good for the economy and the market, but, like most observers, I have my worries. The first is valuation. The S&P 500 is now trading at about 17 times 2014 earnings and probably 16 times next year’s estimate. I look at trailing twelve month earnings and, on that basis, “bubbles” occur at 25 to 30 times, some distance from the current level. Those who believe that the market is approaching a bubble condition may be using the so-called cyclically adjusted price-earnings ratio (CAPE) developed by Robert Shiller of Yale. When market valuation is analyzed this way, the price-earnings ratio is now 26, definitely putting the market in overvalued territory, based on the history of this series. The CAPE method worked well in the 1980s, the early 1990s and leading up to the decline of 2008-9, but the market has continued to rise in the past half-decade in spite of its warnings. I take note of what the CAPE is saying but its message is not central to my strategy work. It reminds me of the dividend discount model I developed at Morgan Stanley in the 1980s which related the level of the S&P 500 to the yield on the 10-year U.S. Treasury. The model worked well in the late 1980s and early 1990s and I thought it would carry me through to retirement. It was a sad day in the mid-1990s when I realized it was no longer relevant.
The valuation context could change if earnings fell short of estimates. Right now analysts seem to be stepping up their forecasts. I started the year thinking the S&P 500 would earn $US115, but there are now forecasts out there as high as $US120 for this year and $US127 for 2015. This has occurred in spite of the preponderance of negative guidance being given to analysts by the companies they follow. The favorable earnings outlook would change if the United States slipped back into a recession, but most of the indicators I am reviewing suggest that is unlikely to happen anytime soon. Based on a study by Omega Advisors, which draws on a number of sources, the market peaks about seven months before the economy starts to decline, but the market has not definitively topped out yet and the economy still appears to have some momentum. The Omega study lists a number of conditions that would typically characterize a recession/pre-recession state: inflation is increasing, the yield curve is inverted, inventories are heavy, employment is declining, weekly jobless claims are around 500,000, and leading indicators, industrial production, consumer confidence and the stock market are declining. Almost none of these conditions are in place now.
The one economic area I am concerned about is housing. With the improvement in employment and continued low interest rates I would have expected the monthly figures on housing starts, new and existing home sales, and mortgage applications for purchase to be consistently strong, but the data have been mixed. I wonder if there are some secular changes taking place in terms of more flexible lifestyles, as well as delayed marriages and family formations. Housing is a key component of growth, so this is an area that bears close attention.
It probably is reasonable to worry about the quality of earnings. Interest rates are low and most corporations have deductions or credits that enable them to have a favorable tax rate. As a result, profit margins are at an all-time high and I do not expect them to revert to the mean any time soon. Even if they did, the market peak tends to occur up to a year after margins peak. Earnings per share are increasing at a high-single-digit rate, but revenues are expanding more modestly (4%-5%). Profit margins can remain lofty, but an important factor contributing to earnings per share growth has been share buybacks. Corporate net income has increased more in line with revenue growth. Companies have considerable cash on their balance sheets and share buybacks are viewed as a more tax-efficient way to reward shareholders than increased dividends, but dividend payouts have been strong this year. Share buybacks are likely to continue, but it is important to recognize the significant role they are playing in earnings per share growth. The rise in the stock market is being driven by factors other than pure net income increases.
There are other ways to look at valuation besides price-earnings ratios. At the market peak in 2000 the S&P 500 was selling at 2.2 times sales, according to a study by Ned Davis Research using Compustat data. The ratio at the peak in 2007 was 1.5 times. Recently the ratio was 1.7 times. The dividend was 1.1% in 2000; 1.6% in 2007 and 1.9% recently. Price to book was 5.1 times in 2000; 3.0 in 2007 and 2.7 recently. Cash per share to protect against adversity was $US140 in 2000; $US353 in 2007 and $US443 recently. Debt to assets was 36.7% in 2000; 32.1% in 2007 and 23.2% recently. These ratios support the conclusion that the U.S. equity market is generally not as richly priced as it was in 2000 or 2007.
At this point geopolitical turbulence appears to have receded as a market-influencing factor. The situation in Ukraine has quieted down with a cease-fire reported in the pro-Russian regions. President Vladimir Putin is negotiating for more political autonomy for the areas where separatism has strongest support with the hope that punitive sanctions will be lifted. The Russian economy has clearly suffered as a result of the conflict and Putin, having gotten much of what he wanted in Ukraine (as well as Crimea), seems to have opted for a more gradual approach to his objective of reuniting a part of the former Soviet Union. (He called the break-up “the biggest geopolitical catastrophe of the twentieth century.”)
How long the cease-fire will last is an open question, but Europe needs Russia as a customer for its manufactured products and it also needs Russian gas as winter approaches. Europe was on a path to grow 1% before Ukraine erupted, and the conflict has reduced the likelihood of hitting that mark. If we are truly entering a period of negotiation rather than conflict, the 1% real growth target is back in place. In addition, the head of the European Central Bank, Mario Draghi, has announced several steps underway toward monetary accommodation, which should stimulate European growth. All of this is favorable for European equities and ultimately for the U.S. market and the dollar, but the situation is fluid and could reverse toward the negative at any time.
More troubling is the situation in Syria and Iraq. President Obama has ordered air strikes against the Islamic State of Iraq and Syria (ISIS) to prevent the further incursion of ISIS troops into Kurdistan and curb the power of that organization in the region. A number of Arab and European states are fighting alongside the United States. The U.S. has been able to gain more international support for this effort, possibly because the recent beheadings have dramatized ISIS’s barbaric brutality. It is doubtful that air strikes alone will do more than slow ISIS down. The first targets were oil-producing sites in Syria which provided revenue for ISIS’s military operations. ISIS already occupies a reasonable amount of territory which it is not likely to surrender. The Chairman of the Joint Chiefs of Staff Martin Dempsey has said that ground troops may need to be sent in, even though there is no popular support in the United States for that alternative. President Obama has said that the ground fighters will have to be Arabs and Muslims from other nearby states like Saudi Arabia, Iraq, Jordan, the United Arab Emirates and Qatar. While there seems to be broad approval for our air strike efforts against ISIS, there are risks. The organization’s Syrian headquarters in Raqqa is located in the heavily populated area and any bombing there would likely result in civilian casualties, thereby causing international criticism of our efforts.
ISIS’s objective is to establish a “caliphate” or Islamic state in the region. As violent as they are, their political interest seems to be confined to the Middle East. In contrast, we have come to learn about Khorasan, an al-Qaeda related organization which does have attacks against cities in Europe and the United States as an objective. While putting terrorism out of your mind is easy given that it has been more than a dozen years since 9/11, we have been both skilled and lucky in thwarting planned attacks against us. We all hope our protective efforts will continue, but the threat has not gone away.
The nuclear weapons negotiations with Iran seem to have reached an impasse. Part of this is because of the complicated political relationships in the Middle East. Saudi Arabia has been an ally of the United States against ISIS and has encouraged us to provide arms to selected Syrian rebels, which we have resisted. Saudi Arabia is also adamant in not wanting Iran to become a nuclear power and is fearful that any deal which the Americans negotiate will be violated in important ways. In addition, the Saudis are worried that the United States may water down the tough parts of the agreement on the nuclear program to get Iran’s military support in fighting ISIS. The United States is hoping to mollify the Saudis regarding any problems they might have with the nuclear agreement we negotiate with Iran. We are counting on Saudi military support against ISIS, and if Iranian oil production were reduced sharply for any reason, Saudi Arabia will play a role in making up the difference. The interrelationships among Saudi Arabia, the United States and Iran are tenuous at best and a breakdown at any level could result in higher oil prices. I have expected an agreement which would result in Iran limiting its nuclear enrichment program, but the progress has been erratic and a turn for the worse could have a negative market impact.
On Israel/Gaza, a cease-fire is also in place, but this is a conflict that is likely to be with us indefinitely. Both sides have made demands that will be hard to reconcile, so a permanent peace agreement is unlikely to be negotiated soon. The large number of Palestinian casualties has resulted in considerable criticism against Israel, particularly in Europe, but Israel argues that it was just defending itself against Hamas’ missile attacks. It is hard to see any basis for agreement because the two sides are so far apart. I am going to the Middle East this month and specifically to Israel in November. Hopefully, I will have a more informed opinion when I return from these trips.
Finally I worry about the South China Sea. As the second largest economy in the world, China can be expected to have a political voice that it wants everyone to hear. China believes it has fishing rights in waters claimed by Japan and the Philippines and oil drilling rights in offshore Vietnam. My view has been that China is not willing to go to war over these issues. Right now, the leaders are preoccupied with their reform program, which includes a vigorous anticorruption effort, regulatory changes and a rebalancing of the components of gross domestic product in favor of the consumer sector by diminishing investment in state-owned enterprises and infrastructure. That’s a full plate of domestic issues which I think will be the primary focus of China’s near-term initiatives. Foreign policy will be kept at a low flame.
I also worry about the dysfunctional democracy we have here in the United States. The current Congress is likely to prove to be one of the least productive in history in terms of producing legislation. That may please some gridlock zealots, but there is much that needs to be done in Washington. I do not expect this condition to change even if the Republicans gain control of the Senate in November. That’s the bad news. The good news is that what happens in Congress over the next few months is not likely to have much of an impact on the economy or the market. The big worries are elsewhere. A market coasting on positive sentiment is, however, likely to overreact in the face of negative developments.
Byron Wien is vice chairman of Blackstone Advisory Partners.