In the minutes of the last Federal Reserve Board’s Open Market Committee that were released last week, a number of the participants said keeping interest rates low could contribute to a build-up of financial vulnerabilities and pose future risks to the economy through increased borrowings, financial leverage and valuation pressures that could amplify an adverse shock to the economy.
It’s difficult to argue the case that equity markets aren’t over-valued. Warren Buffett has a long-standing and relatively simple measure of assessing whether markets are under or over-valued.
Warren Buffett’s metric for whether stock markets are over-heated has never been as stretched.Credit:AP
His starting point has been that long-term corporate profitability is close to long-term economic growth and therefore, over the long term, the value of the sharemarket should closely reflect the growth in the economy.
In the US, while the capitalisation of the US market has risen 307 per cent since March 2009, GDP has grown only 50 per cent.
Where the ratio of the market capitalisation to US GDP was about 93 per cent in 2009 it is now above 160 per cent. When Trump became president in January 2017 it was about 104 per cent.
That ratio has never been at levels remotely close to its current setting. At the peak of the dot-com boom ahead of its bust in 2000 the ratio peaked at about 146. It was just under 140 per cent ahead of the financial crisis.
Another measure, the latest version of economist Robert Schiller’s cyclically adjusted price-earnings ratio, shows that the market is trading on a multiple of earnings – just over 36 times – that has only twice been exceeded. The most recent was at the peak of the dot-com bubble when it hit 48 times. The time before that was 1929 when it reached 40 times earnings.
The market capitalisation of the ASX, incidentally, at about $2 trillion, is roughly in line with Australia’s GDP. Its peak was just ahead of the financial crisis when the ratio of market capitalisation to GDP reached 144 per cent. The big difference between our market and the US is, of course, the big technology sector that has been the main driver of growth in the US market.
The key reason the US market is so inflated is low interest rates and therefore the absence of any attractive alternative for investors.
The concepts of investment fundamentals and of risk, which would otherwise be foremost in investors’ minds, have evaporated because of a market conviction that the Fed will bail them out at the first hint of trouble because of the implications of a stock market implosion for the real economy.
That conviction was reinforced by the Fed’s actions in 2018 when it was in the process of trying to normalise US rates and its own balance sheet, raising rates and shrinking a balance sheet swollen by its post-GFC purchases of bonds and mortgages.
When the Fed hinted that it would continue to raise rates and run down its balance sheet the market tumbled, falling 20 per cent in the December quarter of that year, forcing the Fed to reverse course and lower rates three times last year. It has also reinflated its balance sheet.
With an effective Federal funds rate of just over 1.5 per cent and a $US4.2 trillion balance sheet the Fed doesn’t have the same capacity to respond to a new financial crisis, or market implosion, that it did in 2008. Coming into the crisis the federal funds rate was about 5.25 per cent.
The outlook for US and global growth is subdued, so it is unlikely that growth in US GDP will bring the US stock market and the underlying economy back into line with their longer-term relationship.
It is conceivable that the coronavirus, or another flare up in the trade wars, or some other event might cause the Fed to cut US rates again and embark on another very large bout of quantitative easing, providing more support for markets and over-leveraged companies and households.
It is questionable, however – and even the Fed questions its ability to deal with financial market risks and excessive indebtedness – how effective that might be in halting the stampede of selling that would occur if investors lost faith in the market’s ability to climb indefinitely.
Could the coronavirus be the left-field ‘Black Swan’ event that blows up the markets?
It is possible, if it continues to spread and its impact on global growth through the increasing damage being done to China’s economy and, via the deepening disruption to global supply chains and markets, the rest of the world.
If it isn’t the coronavirus, however, at some point something will emerge to deflate the US stock market, gently or otherwise, so that its level more closely reflects that of its underlying economy and Warren Buffett’s rule of thumb.
Stephen is one of Australia’s most respected business journalists. He was most recently co-founder and associate editor of the Business Spectator website and an associate editor and senior columnist at The Australian.
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