The Short View

February 14, 2012 1:03 am

Free money rally

Investors must now ask if they should buy in, even after gains in risky assets

Even as Athens burnt, the news that Greek politicians had legislated for more austerity for the country allowed the global equity rally to enter its 20th week in good form.

Investors who have been sitting on the sidelines must now ask whether they should buy in, even after gains of 20 per cent-plus in risky assets.

Those with a long-term outlook may well be deterred by the elevated cyclically adjusted price/earnings ratio (CAPE), often known as the Shiller PE. Popularised by Yale’s Robert Shiller, this aims to strip out the effects of the economic cycle by comparing share prices to 10 years of profit, adjusted for inflation.

At its current 22 times, it looks elevated. The CAPE was at or above 22 only from 1928 to 1930, briefly in 1937, intermittently from 1964 to 1969 and from 1995 to 2002.

Only in the last of these periods would shareholders have made money, after adjusting for inflation, over a decade (ignoring dividends, which would have given a big boost). Investing in 1995-1997 only made money because the dotcom bubble was swiftly followed by the credit bubble, pushing shares up again.

The idea behind CAPE is that valuations will eventually return to long-run averages. Behind this is the sensible idea that today’s elevated profit margins will revert to normal.

There are two reasons this might not happen. Central banks are offering virtually free money across developed markets, and companies are investing relatively little.

If free money leads to inflation, it will be bad for shares (higher inflation has meant lower valuations, at least since the 1950s). Equally, if companies increase capacity they raise competition, which will be bad for profit margins.

To want shares for the next decade one should hope central bank cash will be channelled into asset prices, not inflation, and companies will not expand. This is the worst outcome for the economy, but could reinflate asset bubbles.

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