In the minutes of the Federal Reserve Board’s latest Open Market Committee, published last week, some participants said keeping interest rates low could contribute to an accumulation of financial vulnerabilities and present future risks to the economy through a increased lending, leverage and valuation pressures that could amplify a negative shock to the economy.
It is difficult to argue the case where the stock markets are not overvalued.
Warren Buffett has a long-standing and relatively simple measure to assess whether markets are undervalued or overvalued.
His starting point was that long-term corporate profitability is close to long-term economic growth and therefore, in the long term, the value of the sharemarket should closely reflect the growth of the economy.
In the United States, while US market capitalization has increased by 307% since March 2009, GDP has grown by only 50%. Where the market capitalization to US GDP ratio in 2009 was around 93%, it now exceeds 160%. When Trump became president in January 2017, it was around 104%.
That relationship has never been at remote levels close to its current setting. At the height of the dot-com boom ahead of its collapse in 2000, the ratio peaked at around 146. It was just under 140% in the face of the financial crisis.
Another measure, the latest version of the economist Robert Schiller with the cyclically adjusted price-earnings ratio, shows that the market is trading a multiple of earnings – just over 36 times – which has only been exceeded twice. The most recent was at the height of the dot-com bubble when it hit 48 times. The previous time was 1929 when he hit 40 times.
The market capitalization of ASX, incidentally, at around $ 2 trillion, is roughly in line with Australian GDP. It peaked just before the financial crisis when the market capitalization-to-GDP ratio reached 144%. The big difference between our market and the United States is, of course, the large technological sector which has been the main growth engine in the United States market.
The main reason why the US market is so inflated is the low interest rate and therefore the absence of attractive alternatives for investors.
The concepts of investment fundamentals and risk, which otherwise would be primarily in the minds of investors, have vanished due to the market belief that the Fed will save them at the first hint of difficulties due to the implications of an implosion of the stock market for the economy real.
This belief was reinforced by the Fed’s actions in 2018 when it was seeking to normalize U.S. rates and its balance sheet, increasing rates and reducing a bloated balance sheet from post-GFC purchases of bonds and mortgages.
When the Fed hinted that it would continue to raise rates and shrink, the market plunged, dropping 20% in the December quarter of that year, forcing the Fed to reverse course and lower rates three times l ‘Last year. It also reinflated its budget.
With an effective federal funds rate of just over 1.5 percent and a budget of $ 4.2 trillion, the Fed does not have the same capacity to respond to a new financial crisis, or market implosion, that it had in 2008. Upon arrival the crisis the rate on federal funds was around 5.25 percent.
The outlook for the United States and global growth are modest, so U.S. GDP growth is unlikely to return the US stock market and underlying economy in line with their long-term relationships.
It is conceivable that the coronavirus, or another exacerbation in trade wars, or some other event could induce the Fed to cut US rates again and undertake another very large attack of quantitative easing, providing greater support to markets and companies to excessive leverage and families.
It is questionable, however – and even the Fed questions its ability to deal with financial market risks and over-indebtedness – how effective it can be in stopping the selling crisis that would occur if investors lost confidence in the ability of the market to climb indefinitely.
Could the coronavirus be the left-wing “Black Swan” event that detonates markets?
It is possible, if it continues to spread and its impact on global growth through the growing damage done to the Chinese economy and, through the growing disruption of global chains and markets, the rest of the world.
If it is not the coronavirus, however, at some point something will deflate the US stock market, gently or otherwise, so that its level more closely reflects that of its underlying economy and the empirical rule of Warren Buffett.
Stephen is one of Australia’s most respected corporate journalists. He was recently a co-founder and associate editor of the Business Spectator website and associate editor and senior columnist at The Australian.
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