Global equity markets rallied in February to multi-year highs. At the same time, the Nasdaq Composite surged 7.1%, a gain that’s reminiscent of the dot-com era.
As the stock market hits record highs, and the CBOE Volatility Index continues to hover around 14 well below its historical average of 20, traders seem to have adopted a wait and see attitude.
Correction Looms?
The current S&P 500 Index’s price-to-earnings (P/E) ratio is about 18% higher than its historical average of 14.8, according to my research. Some investors worry a price correction may be triggered by bad economic news.
The market nervousness was fueled by the downward revision of the fourth quarter real GDP to the annualized rate of 2.2 percent from its advance estimate of 2.6 percent.
Consumer Demand
The strength of the US dollar has had a positive impact on import demand.
As the US economy is more consumer- than export-driven, the negative impact of the strong currency may be offset by stronger consumer demand.
Real personal consumption expenditures increased 4.2 percent in the fourth quarter, compared with an increase of 3.2 percent in the third.
Fuel Prices
Furthermore, new orders for both transportation equipment and nondefense capital goods increased more than 9% in January compared to the previous month, indicating that the US economic growth remains moderately strong.
The fall in fuel prices is the main culprit for the inflation rate falling to 1.6% in 2014, below the Fed’s target level of 2%.
In Europe, for the first time in history, German five-year government debt sold at a negative yield as inflation in the eurozone continue to fall.
Money Illusion
To pay the government for lending money may be a new normal but lending companies for a negative yield has implications for the future of the equity markets.
The existence of money illusion is disputed by some monetary economists who claim people act rationally.
However, in a deflationary environment where producer prices are falling, wages tend to be sticky as pay contracts are not negotiated downwards.
Workers object to a 1% wage cut. But they remain content if they get a 2% pay rise with 3% inflation even if the effect on purchasing power is the same.
Earnings Outlook
Some analysts find the decline in forward earnings expectations troublesome and expect a major correction in the markets.
It is true that investors are in general risk averse and expect higher premiums for equities than for bonds despite the fact that bond and equity markets are subject to the same economic backdrop.
It is also true that the US companies financed share buyback programs and dividend payments through debt issuance which increased the overall operating leverage of companies.
Under normal circumstances these factors would lead to higher equity premium expectations from shareholders.
Perception Shift
However, in the current environment we believe investors should adjust their equity-premium expectations downwards despite the positive signs in the economy.
That said, we do not think the stock market is currently as overvalued as in the dotcom era.
Consider the so-called Tobin’s Q Ratio. This is commonly used to read the overvaluation of the stock market and measures the market value of the public companies with respect to the replacement cost of their capital.
Although this ratio is currently higher than 1, indicating some overvaluation, it is still around 25% lower than its peak in the dotcom-era.
Furthermore, technological developments have changed the need for capital. Companies such as Facebook (FB) do not require vast capital investments.
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The investments discussed are held in client accounts as of March 12, 2015. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable.
