Are we ignoring stock market bubbles?

October 4, 2016 10:06 am


Are we ignoring stock bubbles forming around the monetary easing and lower borrowing cost trends in the world’s major developed markets?

 

US and other major international equity markets could be due for a 10-20 per cent correction in the fourth quarter, as fundamentals diverge dramatically in stock market valuations. The MSCI World Index shows a strong surge in stock prices since 2011. The benchmark rose from 1,129 points in 2011 to a high of 1,803 in mid-2015. It fell to 1,468 in January/February 2016 when the stock market crash in China and worries over its growth dragged down most world exchanges. Equity prices then regained most of their lost ground, rising to 1,744 by the beginning of the fourth quarter.

 

A closer look at regional equity markets tracks similar rises. The MSCI North America benchmark shows a rise from 1,235 in 2011 to 2,185 in mid-2015, sharp losses in February 2016 over China growth fears, and a recovery by September 2016. The distinct valleys in February 2016 signal that China worries and oil prices weigh the most heavily on the N. American indices. Pacific-region stock exchanges performed comparably to the US equity markets, tracing an almost identical course between 2011 and 2016.

 

Bucking the trend are European indices, which show a less resilient price picture as the bloc was going through a severe financial and sovereign debt crisis for most of 2011-2013. After losses for most of 2011, the Stoxx 600 showed steady gains from 222 points in 2012 to 411 points in mid-2015, when they were boosted by better investor sentiment in the wake of the European Central Bank’s quantitative easing programme. In 2016, however, the Stoxx 600 showed relative losses amid seismic events like the Brexit and continued deflation in the commodity markets, with the index ranging between 325-350.

 

While there’s a bull run in terms of stock prices, the earnings trends appear more bearish in nature, adding to the case that a distinct divergence is overstretching market valuations – and resilience in the face of unexpected shocks. S&P 500 earnings started diverging from prices in October 2014, as optimism rose that the Federal Reserve was set for an interest rate hike. The key rate hike triggered an enormous amount of positive investor sentiment; explaining the risk-on equities buying that fuelled the price rises. On the other hand, in the last few years, earnings on the S&P 500 followed the opposite path to prices, falling from an average EPS of 102 in October 2014 to an average of 86.92.

 

Judging by average PE ratios at the overall index level, valuations are being stretched by diverging earnings versus price trends. The ECB was relatively late to start QE, meaning the European stock exchanges took a less inflated course between 2011-2014, and this is reflected in the trailing average PE ratios at the largest exchanges. Germany’s DAX is at 24, and the performance at the CAC 40 is 22.3 for the year to date. In the UK where the BoE has been running a steady QE programme since 2009, the FTSE 100, by comparison, is currently running an average PE ratio of 55.6. In the US, average PE ratios are at the level of 40.8 on the NASDAQ and 20.1 on the S&P 500. Whether the situation normalises or worsens depends on whether earnings rise or stock prices fall.

 

There are a number of macroeconomic factors that could burst the bubble of high stock prices versus underperforming earnings. The biggest threat appears to be the slowdown of the gigantic economic force of China, which even gave the Federal Reserve pause in deciding on the timing of the next interest rate hike in the US. As one of the world’s rapidly industrialising countries, China hungrily consumes iron ore, crude oil, coal and base metals and has been a core staple of demand appetite. In 2014, however, China’s growth started falling, with the country striving to maintain a six-to-seven percent GDP rate from a high of 10 percent in the preceding decade. Amid sliding demand from China, listed multi-national mining companies and energy companies that supply it are facing considerable challenges.

 

The vulnerability of mining and energy companies lies in falling profits and turnover, and in whether they can adapt quickly enough to China’s new situation. Energy giants Baker Hughes, Cabot Oil and Gas, Chevron and Conco are all listed on the S&P 500 and each of them operates in China. Australia’s large-cap listed mining companies like BHP Billiton all have significant interest in selling metals to China and have most recently shifted their attention to materials for consumer goods like cars rather than construction as a source of future growth. Obviously the company profits and turnover of these juggernaut companies are affected with each GDP reading from China.

 

In the developed economies, macroeconomic indicators are anaemic, meaning another divergence versus stock prices. The US economy is still in slow-growth mode, Europe isn’t improving fast, and the UK now faces the additional challenges linked to the Brexit process, challenges like overall uncertainty, or the weaker Pound Sterling affecting investment prospects.

 

How long can this delicate situation go on for? There are many factors which could trigger a correction; Chinese debt woes or another slide in its GDP growth; US elections; the next Federal Reserve rate hike; the Brexit’s Article 50; oil market shocks; the list goes on. Provided we don’t ignore the possibility of stock market bubbles, the alert investor should be able to prepare for any of the worst-case scenarios.

Tags:

Chief Market Strategist for the Gulf and Middle East region at FXTM, and host of the popular evening business show on CNBC Arabia, Bursat  
Read More >>



AMEinfo EXPERTS