Now may be a sensible time to panic
Sunday 02 November 1997
For those who try to time markets, two reasonable conditions for selling would be if markets were massively overpriced, and if they had begun to show signs that the party was over. This looks to me like a very good description of the main world stock markets today. Contrary to the unanimous views of the good and the great, now seems to me to be an excellent time to panic.
The reasons being put forward for not panicking are more notable for their psychology than their logic. Robert Rubin, the US Treasury Secretary, was early in the field. He claimed that the US economy is in wonderful shape. But this is irrelevant to whether stock market values have become absurd. Indeed it must be highly improbable that the stock market would become overpriced if the economy did not appear to be doing well. The US seemed to be in great shape in 1929 and the perfection of Japan in 1989 was universally acknowledged. It turned out, however, that things were not what they seemed for two reasons. First stock markets were dangerously high, and secondly stock markets matter to the economy. Sadly, central bankers persistently under-rate the importance of stock markets. If they did not, they would tighten monetary policy to prevent them getting out of control. If we have a crash, as seems probable to me, the failure of central bankers to dampen the current stock market bubble will be seen as one of their big misjudgements this century.
Mr Rubin's calming words, perhaps because they echoed so closely President Hoover's comments in 1929, were followed by the largest fall in Wall Street's history and a new set of reasons for not panicking hit the papers. One was the degree of the fall. It was simultaneously proposed, often in the same article, that the market was no longer overpriced because it had fallen and that no real concern should be felt because it had hardly fallen at all. We were reminded that Hong Kong had fallen 40 per cent, while New York and London were still well up this year. This was not put forward as a reason for switching, but as a reason for staying put.
The massive overvaluation of Wall Street is not a secret. Alan Greenspan, chairman of the Federal Reserve, pointed this out when it was cheaper than today. But it didn't make him popular, and he has since seemed to back off. Some think this is because he has seen that his arguments were poor, others that he did not care for the response. It is clear that Wall Street is massively overpriced, because both p/e ratios and the return on equity capital are high. As it is a basic tenet of economics that the cost of capital must equal its return, the stock market should now be selling on a very low p/e multiple.
The bulls argue that Wall Street is not expensive on the grounds that the return on capital is high. They claim this will continue and that this justifies the high p/e ratings. This argument is truly bizarre, as its conclusion does not follow from its premises. Both the bulls and the bears agree the return on equity is high, the difference is that the bulls claim this justifies high p/e ratios, and the bears low ones. The difference is between the bears who follow orthodox economics and the bulls who ignore it.
Knowing that the stock market is overpriced does not mean that it is about to fall. If markets rose when they were cheap and fell when they were expensive, they would not be volatile. Without this volatility, they would not give high returns. After a long bull market everyone knows about the high returns, but the associated volatility is not forgotten so much as deprived of its terrors. Volatility makes equity investment dangerous, but in the current turmoil it is often put forward as a reason not to sell. These comments assume that volatility means short sharp falls from which shares rebound quickly, like 1987, not serious crashes like 1929 in the US, 1972 in the UK and 1990 in Japan, when shares not only fell by two-thirds or more, but investors had to wait up to 25 years to get their money back.
The reason to worry about stock markets is that they are so overpriced, and this is the main reason to worry about the world economy. All previous bubbles have ended in tears and there is a great risk that this one will, too. When markets became similarly overpriced in 1929 (US), 1937 (US and UK), 1972 (US and UK) and 1990 (Japan), they were followed by crashes, and every crash was followed by a severe and long recession. It is usual to point to 1987 as an example of how central banks can save us from the economic consequences of crashes. We are in danger of learning the wrong lesson. Even at its peak in 1987, Wall Street was not expensive. Rapid recovery from a bout of nerves is quite different from expecting Wall Street to bounce back when it is seriously overvalued. This is simply expecting it to remain overvalued all the time, except for the occasional blip that provides a wonderful buying opportunity. This cannot be a reasonable description of stock markets. If it were, such blips would never occur.
The issue for those who try to time stock markets is whether the recent turmoil is a sign of serious problems or just a little local difficulty that should be ignored. There is a strong case that the problems in Asia are real and will be the trigger that brings down Wall Street. Asian countries have high savings rates and large pools of labour. They can expand the production of manufactured goods, but they cannot do the same for raw materials or services. The result is that world prices of manufactured goods should fall, relative to other prices. This has been happening, but quite slowly. As the crisis in Asia brings recessions and devaluations, the process will speed up sharply.
The troubles in Asia will thus speed up the decline in prices and cause the US trade balance to shoot up. But, as unemployment is exceptionally low, US wages will continue to rise. Rising costs and falling prices will naturally lead to falling profits and poor cash-flow. The US stock market is not only dependent on rising profits, but also on strong corporate cash flow, since companies have been buying in their own shares.
The events in Asia may seem to be marginal to the western hemisphere, but it is a well-known truism of economics that prices are determined at the margin.
Andrew Smithers is principal of Smithers & Co, an investment advisory firm.
q Hamish McRae is away.
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