The current debate about equities takes into account the fact that quantitative easing (QE) – and extreme asset purchasing by the Federal Reserve – has inflated equity prices, leading to speculations that we may be heading into bubble territory. As averag
QE has had the effect of driving interest rates globally to abnormally low levels, well beyond equilibrium levels observed in modern economic history. “This artificial engagement in markets by the world’s major central banks is designed to encourage investor capital out of the ‘safety’ of short-term cash to avoid the negative real interest rates on offer,” says Paul Stewart, director of Grindrod Asset Management. He also points out that investors are being driven into more speculative investments that will hopefully increase capital expenditure and encourage economic growth in the medium term.
“QE is an experimental policy, so the actual results may differ from the desired results and the world may have some unintended consequences to deal with in the next decade as QE unwinds,” he warns.
Mike Tonkin, market commentator at Saxo Capital Markets SA, says that one would be forgiven for thinking economic recovery looks likely when one looks at current prices in the global equity and fixed-income markets, but data suggest otherwise. “Poor economic fundamentals such as GDP growth and unemployment in most developed nations suggest there is a disconnection between asset prices, as the real economy. This has been driven by QE with investors encouraged to take on additional risk to find higher yields in an artificially low interest rate environment.”
Capital is therefore flowing into more risky assets that offer higher yields and better return prospects relative to the prevailing inflation rates.
Stewart says it is not just equities that have enjoyed artificial support, but other risky asset classes, too, like corporate bonds, high-yield credit, real estate and private equity.
Are stocks overpriced?
The question we need to ask is, are stocks overpriced? What typically happens is that a speculative market tends to drive stock prices above their value.
According to Russ Koesterich, chief investment strategist at BlackRock, if you compare equities to alternative asset classes, not to their own history, then they are in fact relatively cheap. “While individual segments of the market may be expensive, it is hard to find a major market where valuations appear particularly stretched,” Koesterich argues.
Equity prices are at or a bit below their long-term average, but they obviously look compelling when compared to cash or bonds. “Real cash yields are negative in the United States, the United Kingdom and Europe,” says Koesterich. “With bond yields close to record lows, not only is fixed income expensive but much of the asset class, particularly sovereign debt, carries heightened risk in the form of record high duration or rate sensitivity.”
Stewart says that equities are generally trading at richer valuations than their normalised earnings – that is, profits – would support, but they can probably not be characterised as being in bubble territory yet. “This is obviously a broad statement in relation to index levels, but it would be fair to say that selected equities in many countries could be found that are both very expensive and quite cheap,” he says.
Koesterich says that, given how cheap stocks were when the rally began, most traditional valuation metrics suggest that most global markets are fairly priced. But he cautions that investors still looking to find value in a world in which most asset classes are being distorted may have to pursue cheap markets in what he calls “somewhat frightening parts of the world”. It may be that investors should ride out the current volatility and perhaps wait for a correction.
The real bubble is in the bond market
We may not be in bubble territory, as such, but caution is advised, says Koesterich, because reasonable valuations, particularly in the US, are partly a function of record high profit margins.
“Stock selection will be a key attribute that fund managers will need to demonstrate as the world normalises over the next few years and QE is gradually withdrawn from the market,” predicts Stewart. “Care will need to be taken to avoid overvalued companies that thrived on QE, while opportunities in some more appropriately valued securities can still be found for the nimble fund managers.”
Meanwhile, the real bubble is in the bond market. “Cheap money looking for yield has found a home in emerging market sovereign bonds as well as corporate bonds. With US interest rates set to normalise on the back of the recovery and reduction in QE we are already starting to see the effects of the ‘punch bowl’ being removed from the party,” says Tonkin.
Editor’s thoughts:
With the end to QE nowhere in sight, we continue to see stock markets outperforming against a backdrop of stagnant economic growth – and the JSE is no exception. The monetary stimulus is expected to continue into 2014. Do you think we are in bubble territory, or approaching it? Comment below.
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Added by Fergus, 27 Jun 2013