Much is continually being made of the fact that the stock market is entering its sixth year of a bull market run and as most bull markets last 5-8 years this one is getting long in the tooth. John Authers' article in Monday’s FT delves into this very question. Mr. Authers quotes two Yale University economist’s measures named after them, Shiller Cape and Tobin q. One measure attempts to adjust valuations by taking out the cyclical element of earnings, the other captures the ratio of the stock markets capitalization to the total replacement value of its assets. I have referred to both of these measures before (Just use common sense and The Nobel Prize) and pointed out that on these measures, the S&P 500 currently looks expensive relative to history.
Equities, particularly US ones, don’t particularly look cheap on any historical valuation matrix. It is worth remembering, cheap and expensive is a relative term, cheap relative to what? As we mentioned Professor Shiller and Tobin use historical valuations, if you look relative to other asset classes perhaps they do not look so bad.
BCA research point out that stocks tend not to go into a major cyclical decline without an impending economic recession, although predicting economic recessions is not easy. We would suggest recessions tend not to happen when virtually every central bank in the world is putting all their collective might into creating the opposite effect.
Traditionally the most likely signal of an impending recession is the movement of the yield curve. Simply put, the yield curve is the difference between deposit rates and rates charged to borrow for extended periods of time, specifically ten years and beyond. A big gap between short-term interest rates and a long-term one is described as a steep yield curve, and signifies a positive view on the economy. If that gap closes either by short-term rates rising or by long-term rates falling, analysts view this as higher risk of an impending recession. Relative to history, current yield curves are pretty steep, but have flattened modestly recently.
One can see from the chart, how the current yield curve (the red line) is slightly flatter than a month ago (the grey line).
We pointed out in Monday’s blog that longer dated US treasury yields surprisingly fell on Friday, (the curve flattened) post employment data that suggested the US economy was continuing to recover. This move in treasuries probably spiked the sell-off in equities.
Central banks have made it clear that they are not in the mood to raise interest rates in the near future. So will long-term rates continue to fall? Possibly, but if that were to happen, a fall in long-term rates would make the real return on equities look more attractive, assuming those returns could be maintained. It’s a strange old world; it was not so long ago market commentators were fretting about rising long-term yields. What ultimately makes equities look attractive is earnings growth; we may get a better indication of that in the coming weeks.