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Buried in the latest Fed meeting minutes was the revelation that the US Central Bank staff believe that vulnerabilities associated with asset valuation pressures had edged up from notable to elevated. This meshes with an increasingly popular view that we are well overdue a correction. After all, the US stock market typically suffers a 5% dip about four or five times a year.
We haven't even seen a hint of one since early 2016. And even this month's nuclear sabre rattling could only elicit a listless 1.5% decline. And indeed, the S&P 500 is only fallen by 1% or more on three trading days this year. And over the past two decades, it has averaged roughly 36 such drops a year. And meanwhile, valuations are starting to look very stretched.
Using the flawed yet popular CAPE valuation metric, US equity prices have only been higher than today at the peak of the Dot Com bubble, having recently surpassed the levels seen ahead of the Black Tuesday crash in 1929. Prognostications of an imminent crash have climbed in tandem and not just from the crowd of usual perma-bears.
Almost half of fund managers polled by Bank of America reckoned the equity is overvalued, the highest reading since the survey began in 1998. Investors from Bill Ackman to Dan Ivascyn say that they are now girding their portfolios for stormier weather. Nonetheless, the rally isn't built on quite shaky ground as many people think. The US economy continues to trundle along at a steady, if unspectacular, pace.
Quiescent inflation has quashed the chances of aggressive interest rate increases from the Fed, and corporate America just delivered a second juicy quarter of double digit earnings growth this summer. Now, admittedly, the earnings have been helped by comparisons to last year's underwhelming results. But Management Gardens has been upbeat, and the weak-kneed dollar will bolster the profits of many US companies in the quarters to come.
Now, clearly risks are more elevated today. And even without a ruinous crash, it will be hard to sustain in stock market's post-crisis rally, for long term investors will have to moderate their return expectations. But a severe reversal this year is unlikely. History shows that low volatility, high valuation environments can persist much longer than many expect.
