Virtually no one believes in the continuing bull market in US stocks. That is perhaps the best argument that it can carry on for a while – when a bubble is ready to burst, it is usually when all the “bears” have given up, and investors have fully entered.
The reasons for doubt are well known. The economic recovery in the US is anaemic at best, while growth in many of the emerging markets that have helped the rise of US multinationals has slowed significantly – meaning, presumably, lower profits. Unemployment remains unacceptably high.
There is an argument that this apparent dichotomy can be resolved, because the interests of US companies are not identical with the interests of the economy.
US corporations have aggressively cut costs and boosted productivity, and they are holding on to their cash rather than waste it on questionable investments. That has pushed up profit margins to historically high levels.
This is exactly what their shareholders want. But it is exactly what politicians do not want, as such activities do not contribute to economic growth. Hence rising share prices have coexisted with rising inequality, and rising public disillusionment.
But even these arguments can be tricky. Profit margins tend over history to revert to their long-term mean – which means they should be due to come down.
Finally, there is the argument about the impact of the Federal Reserve. The rally of the past five years has correlated almost perfectly with rises in the Fed’s balance sheet, as it buys more bonds in an effort to push up asset prices. When the Fed suggested it would start tapering off that support earlier this year, the result was a sharp fall for stocks. Once the Fed follows through on this threat, and that will have to happen at some point, the market will have to sell off.
This argument too has its weaknesses. When Ben Bernanke, the outgoing Fed chairman, started talking about “tapering” bond purchases earlier this year, the market treated this as a synonym for “tightening”. But the two are not the same.
Bond purchases are one way to keep interest rates in the economy low. It is a flawed method, which distorts the bond market. The Fed would prefer not to keep buying bonds, but still keep rates low by offering forward guidance to show that rates will stay low for a long time. So even if tapering of bond purchases does get under way next year, as is likely, rates could stay low for a while. That will support stocks.
What then could push stock prices lower? Corporate earnings might appear a good candidate. Earnings have been roughly flat during the rally, which has relied almost wholly on an expansion in the multiple that people are prepared to pay for those earnings.
But markets have a momentum of their own. According to Adam Parker, Morgan Stanley’s chief US equity strategist, there have only been three periods in the past four decades when earnings multiples on the S&P 500 rose so far over a two-year period. In each case, the market continued to rise for at least another year, and in two cases (1991 and 1996) it kept gaining for another two years.
So even if stocks are already too expensive, which they are, there is nothing to stop them becoming even more expensive before they correct.
An outright fall in earnings could bring down share prices, even if multiples stay high. And there are plenty of risks to earnings. Multinationals are complaining that the fall-off in demand from the emerging markets is worse than they had anticipated; China in particular could yet drive a sell-off; and of course the European crisis has been in abeyance for more than a year now, without convincing anyone that the eurozone’s problems are over. However, on balance an outright fall in earnings seems unlikely.
Finally, we must look at investors’ behaviour. While this continues to be one of the most hated bull market runs of all time, retail investors are starting to believe. According to Avi Nachmany of Strategic Insight in New York, total flows into equity funds this year are on course to equal inflows for all of the past four years combined – about $450bn.
There remains a lot of cash out there to be invested. Once investors start chasing returns in the stock market, they can push it up quite a bit further.
In the short run, this shift by retail investors suggests that stocks can keep rising; markets have their own momentum. In the longer run, retail investors tend to be terrible investors, buying at the top and selling at the bottom.
If, as seems likely, the Fed under Janet Yellen keeps rates low and there are no external shocks, then a “melt-up” seems entirely plausible. Investors would keep socking money into the market until they created a bubble. Bubbles always burst.
Indeed, it is hard to disagree with Jeremy Grantham, the expatriate British fund manager who founded GMO in Boston. He said this week that the Fed’s regime of “excessive stimulus” would continue and “the path of least resistance for the market will be up”. Adding that there are “few signs yet of a traditional bubble”, his best guess is that the market moves higher for another year or two before “the third in the series of serious market busts since 1999”.
Timing bubbles is extremely dangerous. In the short run, it could be embarrassing to be out of the market; in the long run it could be disastrous to stay in it. Either way, there are good reasons why this bull market run remains so unpopular.
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