Dr Sushil Wadhwani: Some stock market excesses still need purging

From a speech by the member of the Bank of England Monetary Policy Committee, delivered at Edinburgh University
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Business confidence has declined very significantly in recent months, but global stock markets appear to believe that a recovery is around the corner. In the US, the key downside risks are that the ongoing deterioration in the labour market might impact further on savings behaviour, and weak profitability might keep lay-offs high. On the other hand, a possible upside risk is that the post-11 September decline in confidence proves to be relatively transient.

Global stock markets have fallen significantly since their peaks in 2000. Declines in the major equity indices from their peak values have ranged from more than 20 per cent for the FTSE100 to about 60 per cent for the Nasdaq. It is, therefore, tempting to believe that, perhaps, stock markets are unlikely to go down much further.

Normally, bear market bottoms are associated with clear signs of the purging of the excesses that built up during the euphoria associated with the preceding bull market. However, the current price-earnings ratio for the S&P500 index in the US remains high by long-term historical standards. These high absolute valuations have led some commentators to argue that the US stock market is still vulnerable to a further, significant decline.

It must be noted that P/E ratios have been high by historical standards for some years, and several Wall Street strategists have argued that this has been appropriate because interest rates and inflation have been low and that holding equities has become less risky. Indeed, at present, a survey of recommendations of Wall Street strategists suggests that they believe this is one of the best times to buy equities in the past 16 years.

Although global stock markets are down significantly over the past 18 months, it is not, as yet, possible to assert that all the previous "excesses" have been purged. Current valuations still appear to be predicated on estimates of medium-term earnings growth which, while not impossible, only occur infrequently. Individual investors appear to still have an unrealistic expectation of future, long-term equity returns.

However, none of these "excesses" are necessarily inconsistent with a significant move up in equity prices over the next few months if, say, clear signs of an economic recovery do emerge. It behoves us to recall the fact that equities rallied by almost 60 per cent over the subsequent 17 months from the lows reached in October 1998, even though expectations of long-term earnings were not significantly different from today.

An economic recovery that brought forth a significant bounce in profits and share prices is unlikely to lead anyone to question their current, longer-term expectations about earnings and equity returns. Also, if the military campaign were seen to be continuing to proceed well, equity markets and business confidence could recover significantly.

If, on the other hand, for whatever reason, the recovery is delayed further, then we might see a valuation adjustment as investors come to re-evaluate their expectations about longer-term earnings growth and returns. Recall that, earlier this year, we have already had two failed rallies (January, and April-May) in the expectation of a recovery. When it appeared that the economy was actually getting weaker, the stock market fell significantly, and provided further downward impetus to the economy.

Hence, were the US economy to not recover on the expected schedule, there is the risk that the stock market might then act to amplify the extent of the weakness.

Alternatively, even if the economy and the stock market were to recover strongly over the next few months, it is possible the potentially over-exuberant returns and earnings-growth expectations prove problematic for the markets at some future date.

We shall have to wait and see.