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November 20, 2013 9:04 am
Markets have left milestones for dust. US stock prices are enjoying their best year since 1997, with investors apparently untroubled by the backdrop of a lacklustre economy and high unemployment.
The S&P 500 has barrelled through three century marks this year alone, from below 1,500 to this week’s intraday peak of 1,802 for a year-to-date gain of 25 per cent. The Dow Jones Industrial Average has finally breached the 16,000 threshold, after rising through 15,000 in October, while the Nasdaq Composite is looking to revisit 4,000 after an absence of 13 years since the dotcom bust of 2000.
As the Fed’s balance sheet approaches $4tn, its expansion in recent years neatly matches the rise in the S&P 500, creating unease that an equity bubble is surely inflating as was the case in 2007 and 1999.
Not so according to Janet Yellen, Federal Reserve chair-designate, who told Congress last week that the central bank does not see a bubble in equities based on the metrics of equity risk premium and price to earnings ratios. Ms Yellen also said there is no federal rule to support the stock market.
But in the absence of a strong economic recovery matched by rising incomes, this year’s rapid rise in equity prices is also seen reflecting the activist role of the Fed as it buys $85bn of bonds each month, suppressing interest rates and forcing investors to buy shares, corporate bonds and real estate.
While some investors argue the stock market has not reached a valuation tipping point, the concern is that unless the broad economy and incomes accelerate soon, the prospect of a major correction in equity prices looms.
“Even the most bullish investor would admit that sluggish economic growth, a lacklustre labour market, and political discord are hardly the logical bedfellows of a stock market at new highs,” says Nicholas Colas, chief market strategist at ConvergEx.
“The current market action of a year end melt-up coming after five years of truly solid returns for US stocks, seems at first blush to be irrational performance-chasing. And who knows, it may end up being exactly that.”
Certainly the return of money into US stocks after outflows in 2011 and 2012 has been one catalyst for outsized performance. According to Lipper, investors have pumped a net $285bn into US equity mutual funds and exchange traded funds in 2013, the best year for the market since their records began in 1992.
Countering the concern of a bubble forming, barometers of the economy such as transport and small-cap stock benchmarks are up more 30 per cent this year, reflecting a general consensus of accelerating growth in 2014.
Richard Madigan, chief investment officer at JPMorgan Private Bank, says the current forward P/E multiple on the S&P 500 at about 15 times is well below the reading of 24 times seen in 1999 at the tail-end of a major bull run.
“From a historical perspective, that is roughly what we consider to be fair value. Looking ahead, animal spirits still seem ambitious, but neither hubris nor complacency has currently taken over investor behaviour.”
At the very least, with the Fed set to taper in the coming months, there is a concern that the market’s hefty gains in 2013 have borrowed from the future, particularly as revenues are expanding modestly for many companies.
“The current rally has robbed a bit of next year’s performance,” says Michael Kastner, managing principal at Halyard Asset Management.
Mr Madigan says: “Investing is going to get more complicated as most of the easy overweight investments have just about played themselves out.”
A looming question is whether some investors will take the opportunity to lighten equity exposure ahead of the taper and fiscal battles in Washington.
Tobias Levkovich, US chief equity strategist at Citi, still believes in the secular bull market, but says: “The market is vulnerable to a pullback here; if profit-taking sets in, no one wants to be the last one out of the door.”
As the equity market looks to chalk up more milestones in 2013, the worry remains that the new peaks could become a millstone for late bull run arrivals.
Mr Kastner says: “We seem to have moved from investing under sensible valuations to one of the greater fool theory, hoping there is another buyer willing to pay a higher price at these extended levels.”
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