Central banks have acted as the proverbial tooth fairy towards financial markets in recent years. But they have not just left a small amount of money under the pillow when a child lost its first tooth. Instead they have printed trillions of dollars via Quantitative Easing (QE), to persuade investors to buy shares and commodities, and drive prices ever-higher.
Their justification for this strange behaviour was a belief that this would create a wealth effect, and so somehow restore the economy to its BabyBoomer-led peaks. But now the Great Unwinding of these stimulus policies is underway, starting in China. And so prices on major world stock markets are falling as they return to more normal methods of valuation.
Of course, now they are falling, those who made fortunes in the market from QE are starting to complain. One obvious target are the high frequency traders, whose computer-led trading based on algorithms now accounts for more than 50% of daily trading in many markets. But investors never complained when these same strategies were taking prices ever-higher. It is only now, when bonuses are under threat, that reality is starting to dawn, as JP Morgan wrote last week:
“These technical factors can push the market away from fundamentals. The obvious risk is if these technical flows outsize fundamental buyers.”
Such trading strategies should never have been allowed in the first place, as these “legal highwaymen”add nothing to the process of price discovery – which is the fundamental purpose of any market. These complaints are just noise, however, hiding the real issue – which is shown in the chart above from Nobel Prizewinner Prof Robert Shiller.
It highlights how this central bank support means share prices are now valued at levels well above historical levels, according to his tried and tested Cyclically Adjusted 10 year Price/Earnings ratio (CAPE):
- They are valued at levels previously only seen in recent times in 2000 and 2003-7
- This, of course, parallels previous central support during the dotcom and subprime bubbles
- In turn, this support led to the surge in margin debt used to finance share buying, as discussed last week
- Now, of course, the Great Unwinding of all all this debt is underway
The key question is how to know what real fundamental value should be for shares. Luckily, a simple formula provides the answer to this question. Shiller, like Warren Buffett and many others including myself, is a follower of Ben Graham’s work. Known as the ‘Father of Security Analysis’, Graham developed a simple formula to explain the relvance of the Price/Earnings ratio:
- He showed that a P/E ratio of 8.5 meant markets were expecting zero earnings growth over the next 10 years
- Each 2 point change, up or down, meant they expected earnings to rise or fall by 1% a year for the next 10 years
Thus today’s CAPE ratio of 24.5 means investors are expecting S&P 500 earnings to rise by 8%/year till 2025. Yet earnings are already at near-record levels, so this is clearly impossible. (For a fuller analysis by the Harvard Business Review of Graham’s pioneering work, and its confirmation during the 1987 stock market crash, please click here.)
Analysis can only tell you where you are in the cycle. It cannot tell when a reassessment will take place. But certainly China’s New Normal policies seem to have broken the myth that markets can only go higher. Markets are now looking very fragile indeed, especially as investors worry that the Janet Yellen tooth fairy may have other things on her mind, as I noted last week:
“More QE is needed if stock markets are to move higher. But this could be a very risky move in a US Presidential election year. Populist candidates such as Trump and Sanders might well ask what had happened to the $4tn the Fed has already spent on QE since 2009.”
Over in Europe, ECB President Mario Draghi confirmed on Thursday he is happy to provide his share of the cash. But how easy would it be for the US Federal Reserve to reverse its current course? They have said their next move will be to increase interest rates – and nothing in Friday’s jobs report gave Ms Yellen any excuse for further delay.
It could be quite a volatile autumn if the tooth fairy fails to appear.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 52%
Naphtha Europe, down 52%. “Europe’s naphtha traders are keenly watching macroeconomic data coming out of China but are expected to keep sending volumes east because of excess regional supply.”
Benzene Europe, down 60%. “With price drops reminiscent of late 2008, there is still some uncertainty among industry players concerning market direction for the rest of the year”
PTA China, down 46%. “Winter clothing demand had set in later this year because of the slower economic performance in China, such as stock market volatilities and lower economic growth”
HDPE US export, down 35%. “Domestic export prices slipped a little on the general market trend toward lower prices.”
¥:$, down 16%
S&P 500 stock market index, down 2%