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Stock markets are vulnerable – but they’re not at bubble levels
Let’s not fool ourselves here.
Stock markets are being propped up by quantitative easing (QE) and loose monetary policies around the world. That almost goes without saying. The latest surge in markets – which had been looking a little tired in March - has been driven very much by Japan’s monetary easing.
And if the Federal Reserve decided to end QE tomorrow, markets would not like it. I don’t see the Fed ending QE tomorrow, and I suspect Ben Bernanke will confirm that view tonight when he talks to US politicians.
The point is, I don’t think there’s any argument with the notion that QE has helped to send stock markets higher.
But that doesn’t necessarily mean that stock markets are in a bubble. As Josh Brown of The Reformed Broker blog points out, this isn’t 1999. Even the US – a market which I consider to be one of the least attractive around just now – is much cheaper than it was back then.
In 1999, the S&P 500 was trading on 33 times earnings. Now, it’s on 14. And while it is expensive in terms of the cyclically-adjusted p/e ratio (Cape), at around 24 – which is one reason why I prefer other markets – back then, the Cape hit 45.
Yes, there are lots of reasons to be wary. Profit margins are unusually high, the economic backdrop is weak, banks remain fragile, and central banks are messing about even more than they normally do. But these are not bubble valuations. We talk about markets hitting all-time highs, but what other assets do you know of that are still trading at lower prices than they were 14 years ago?
Better yet, some markets are genuinely cheap. These are the ones that we’ve been suggesting buying for a long time now – Japan, Italy, maybe some other eurozone peripheral stocks if you feel really adventurous (my colleague Matthew Partridge had the nerve to invest in Greece, for example, which has turned out rather well, though it’s not one I’d feel comfortable taking more than a punt on).
QE is a worry. But it’s also very hard to predict when the taps will be turned off. Basing your investment strategy around picking that turning point, and sitting in cash until it comes around, is going to prove expensive.
And while stocks are overdue a correction, you could have said that any time in the past three months now. It’s equally likely that nothing significant enough happens to push them lower, and that everyone who’s worried about missing out piles in and sends stocks a lot higher.
The real bubble is in bonds
In any case, the end of QE will be a much bigger problem for a far more bubbly-looking asset class – bonds.
If you’re looking for bubbles, bonds are the place to look. Taken as a group, yields are close to or at record lows (and therefore prices are at record highs). And unlike stocks, this isn’t coming back from a brutal bear market. This is coming at the tail-end of a 30-year bull market. That sounds a lot more like a bubble to me.
And in case you’re thinking: “but how can it be a bubble if lots of people are talking about it?”, then I’d ignore that. People know when an asset class is in a bubble. Jeremy Grantham of GMO tells a great story about sending a survey to other fund managers at the peak of the tech bubble. To cut a long story short, they virtually all acknowledged that stocks were heading for a big fall – they just weren’t happy to tell their clients that. Perhaps bond fund managers are just a little more honest.
So if you're looking for signs of stress, the bond market is the one to watch. And keep an eye on one area in particular – emerging markets. As the guest speaker at our MoneyWeek Conference last Friday, the excellent Russell Napier pointed out, the government of Rwanda has been able to borrow money at just under 7% for 10 years. If that's not a sign of irrational exuberance, I'm not sure what is.
Russell reckons that the next crisis will kick off in emerging market debt. We'll be writing more about this in the near future – it's going to be a big theme. But you'll also be able to hear more from Russell, and the rest of the speakers from the MoneyWeek Conference very shortly. The recordings are being edited and compiled right now – if you missed the conference, they're well worth getting hold of. We'll be letting you know how, tomorrow.
Got a comment on this article? Leave a comment on the MoneyWeek website, here.
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The FTSE 100 continued its rise yesterday after a good set of company results, and a slight drop in the rate of inflation. The index closed up 0.7% at 6,803.
Miners were in demand. Polymetal was the day's highest climber, adding 8.4% as the price of gold rose. Randgold Resources rose 5% and Anglo American, Evraz and Antofagasta added between 4.4% and 4.1%.
In Europe yesterday, the Paris CAC 40 rose 14 points to 4,036, and the German Xetra Dax added 17 points to 8,472.
In the US, the Dow Jones Industrial Average rose 0.3% to 15,387, and the S&P 500 and the Nasdaq Composite each added 0.2% to 1,669 and 3,502 respectively.
Overnight in Japan, the Nikkei 225 rose 1.6% to 15,627 and the broader Topix index rose 0.4% to 1,276. And in China, the Shanghai Composite slipped 0.1% to 2,302 and the CSI 300 rose 0.1% to 2,618.
Brent spot was trading at $103.80 early today, and in New York, crude oil was at $95.76. Spot gold was trading at $1,390 an ounce, silver was at $22.60 and platinum was at $1,476.
In the forex markets this morning, sterling was trading against the US dollar at 1.5149 and against the euro at 1.1713. The dollar was trading at 0.7732 against the euro and 102.64 against the Japanese yen.
And today, Nationwide, Britain's biggest building society, announced a big rise in profits. Annual underlying profits rose by 56% to £475m. Gross mortgage lending was up by 17% to £21.5bn, giving the mutually-owned company a 15.1% share of the market.
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