Posted 2nd March 2017
It seems like nothing can stop stock markets rising. New highs have become almost a daily occurrence. Ahead of Monday’s trading, the Dow Jones Industrial Average was on an 11-day win streak for the first time since 1992, with 11 record closes in a row for the first time since 1987.
And the bulls are forecasting more of the same. No less a forecaster than Warren Buffett is very happy to be seen amongst the optimists. But before we write off bear markets as obsolete, might there be a snag? Because Mr Buffett’s favourite indicator is telling us to be very wary indeed…
The Trump Rally trundles on
The ongoing “Trump Rally” has sent shares on Wall Street and in London to new peaks after the new US incumbent just promised corporate tax cuts and a spending splurge on infrastructure projects to boost the economy. The Dow Jones has topped 21,000 for the first time – last night’s close was at 21,115, up another 1.5% – while the FTSE 100 is now some 18% higher than a year ago.
The President is certainly playing his part. In his most measured speech to date, according to the Guardian, Mr Trump has just told Congress he would bring back to life dying industries and “crumbling infrastructure will be replaced with new roads, bridges, tunnels, airports and railways gleaming across our very, very beautiful land”.
“My economic team is developing historic tax reform that will reduce the tax rate on our companies so they can compete and thrive anywhere and with anyone”, he says. “It will be a big, big cut. At the same time we will provide massive tax relief for the middle class.”
Wharton finance professor and long-term bull Jeremy Siegel says that the speech was “a thousand times” better than he personally expected and that he was surprised by Trump’s ability to connect emotionally with his audience.
“I thought this rally was on real thin ice” before the president’s speech, Siegel tells CNBC’s Fast Money Halftime Report. But now he says that “I don’t think it’s on as thin ice now.”
Earlier this week the legendary Warren Buffett, chairman and CEO of Berkshire Hathaway, was also talking to CNBC. He put $20bn into the market just before the presidential election. And his current view is that at today’s interest rates, the stock market is “not in a bubble territory”. In fact, US stocks are “on the cheap side” while the dynamism of America’s economy is “unbelievable” and in a “miraculous” boom.
“You’d be making a terrible mistake if you stay out of a game you think is going to be very over time because you think you can pick a better time to enter,” says Mr B.
Phew! So despite everything we’ve seen so far, maybe it’s time to go ‘all in’ on equities before we miss the chance!
But before we do that, I’d like to serve up a sizeable slice of caution.
Let’s gloss over for the moment how Mr Trump’s proposals could lift both the US national debt as well as long-bond yields. Warren Buffett admits that he wouldn’t be so bullish on shares if interest rates were to rise to much higher levels.
Here are my other concerns.
The valuations of a wide range of assets now look as stretched as they did in the summer of 2014, i.e. just before they collapsed, notes Oliver Jones at Capital Economics. For example, the credit spreads – a measure of risk – of some assets have fallen to levels last seen in the run-up to the global financial crisis.
Sure, the surge in credit spreads and accompanying asset price slump that occurred in 2014 was driven by worries about a Chinese ‘hard landing’ China and an associated drop in commodity prices. Those fears proved misplaced last time. And while China is facing plenty of problems, as Jim Rickards recently commented in Strategic Intelligence, the growth slowdown may be only gradual this year.
But Capital Economics accepts that commodity prices have been driven up by excessive optimism about demand and are set to fall back, while the US fed funds rate could increase further this year than markets are currently discounting.
Long-term ultra-loose global monetary policy has driven a “hunt for yield”, says Oliver Jones. This has pushed the spreads of some risky assets to very low levels.
And though historically the biggest increases in credit spreads have tended to happen just before or during recessions – not currently on Capital Economics’ US radar screen – an out-of-the-blue rise in spreads could be caused by plenty of factors, such as the 1998 LTCM crisis and the 1992 US corporate accounting scandal.
To put this another way, there’s an awful lot of good news baked into US and UK share prices right now. And a widening of these credit spreads could unsettle confidence and spark a nasty equity market sell-off.
For my last piece of evidence, though, it’s back to Mr Buffett. He’s well known for saying that the percentage of total market cap relative to US GDP is “probably the best single measure of where valuations stand at any given moment.”
As of the end of February, the Total Market Index was standing at $ 24,844.5bn, according to GuruFocus. That’s about 131.8% of the last reported GDP figure and is the highest level seen since the dotcom crash in 2000.
Yes, I know some people will argue that it’s different this time. There’s always a voice saying so. But it’s also very clear that on this gauge, US stocks are significantly overvalued. Indeed, they’re set to return an average annualised return of minus 0.9% including dividends for the next several years, says GuruFocus analysis.
And when Mr Buffett is choosing to ignore his own favourite benchmark when this doesn’t fit his current bullish view, I reckon there’s a very good reason to be worried about the present level of equity markets.