Have you noticed how many articles have appeared recently scaring investors into thinking “markets have never been so uncertain” as they rattle off the well-worn reasons we should be worried: geopolitical tensions, elections, stretched valuations, extended cycles, the inverted yield curve. If you didn’t know any better, it’s enough to leave you thinking the best solution would be to find shelter and stock up on tinned food.
But many of these articles tend to be absurdly one-sided, you just have to look a bit deeper to find sound arguments to justify where share markets are trading.
1. The bond market is smarter than the share market and bonds say sell
The bears argue: While last year’s share market tumble bottomed around Christmas, bond yields around the world continued to fall, signalling the bond market expects economic growth to slow in the future. What’s worse, share markets have rallied at the same time as forecast company earnings have been going down. How can that make sense?
It’s not just economic growth perceptions that cause bond yields to fall, it’s also the perception of inflation and the fall in global yields is partly a reflection of the ongoing very low inflation we’re seeing around the world and the expectation that it’s likely to continue. For example, over the last 30 years Australia’s core inflation rate has averaged 3.8%, but the latest reading was less than half that at 1.3%.
If you look back over the last hundred years, when inflation is low share markets attract a higher valuation, as measured by a basic price to earnings (PE) multiple. At the end of March, the ASX200 was trading on a PE of 15.6 versus its average ‘low inflation PE’ of 16.5. On that basis, while you wouldn’t argue the share market is exactly cheap, nor is it overly expensive.
Another valuation measure to look at, especially for
income-seeking investors in a low interest rate environment, is the share
market’s dividend yield minus the 10-year Australian government bond yield. At
2.9% the dividend yield is at its equal highest margin above the government
bond yield in the last 25 years – see chart 1.
Chart 1: the ASX200 dividend yield minus the Australian government 10-year bond yield is at an equal high for the last 25 years
More importantly, after accounting for inflation, at less than 0.5% the ‘real’ bond yield is getting perilously low, whereas the 3.4% real yield on shares is almost two and a half times its 25-year average of 1.4% and more than seven times higher than the real bond yield – see chart 2.
Chart 2: the real yield on shares is more than seven times higher than the real bond yield
Another measure is the Earnings Yield of the share market, which is technically the inverse of the PE ratio and essentially tells you the return on equity you should get from investing in shares, a focus for those aiming to generate a capital return on their investments. At 6.4%, it’s bang in line with the 25-year average, another indicator that the market is around fair value, but nevertheless attractive in the context of a low return environment.
Finally, the Equity Risk Premium (ERP) for the Australian market, which tells you how much extra return you should get from investing in shares rather than risk-free government bonds, sat at 4.9% at the end of March, comfortably above its 21-year average.
If you say a market’s expensive, you have to say relative to what. In the context of super low bond yields and an environment where the risk-free return barely leaves you with anything after inflation, equities start to look pretty attractive even if underlying company earnings are a bit weaker.
2. The inverted yield curve
The bears argue: Over the last 50 years every recession in the US has been preceded by an ‘inverted yield curve’, which is where the yield on longer-term bonds is lower than that on shorter-term bonds. Last month the 10-year bond yield snuck below the three-month yield, and we all know when the US sneezes the world catches a cold.
No less an economist than Nobel Laureate Myron Scholes wrote a piece arguing that forecasting a recession will automatically follow an inverted yield curve is no more than ‘data mining’ (an expression used to condemn either lazy analysis or the torturing of data to arrive at a pre-determined outcome). He points out that previous inversions came about because the Fed raised cash rates to an average of more than 2% above inflation in a deliberate effort to slow the economy, whereas in this cycle of nine rate rises it’s never been more than 0.3% above inflation.
In other words, the bond yields themselves don’t cause a recession, it’s what causes the yields to move that matters. In the past, recessions have coincided with the Fed actively trying to slow the economy, whereas this time around, they’ve said they’re trying not to.
3. The cycle is extended
The bears argue: Come June this economic cycle will be the longest on record.
So what, cycles don’t die of old age. Period.
Cycles normally die because of some kind of excess in the economy, and it’s hard to spot any of those right now, or because the central banks have to stomp on the brakes, again, no sign of that.
4. Geopolitical tensions
The bears argue: Pick your poison: Brexit, Trump’s trade war, any other capricious Trump crusade, Russian hacking.
Political shenanigans is a perpetual favourite of share market doomsayers, but the fact is, over the past 10 years the markets have sailed through whatever’s been thrown at them.
The UK share market has risen 11% since the Brexit vote, unemployment is at a more than 40-year low of 3.9% and GDP growth is the same as Switzerland and much better than both of Germany and France.
Trade wars are horrible, but the US’s S&P500 is up 11% since tariffs were proposed in April last year and in fact just hit a record high, the Chinese index is up about 1% over the same period, and the ASX200 has hit a 12-year high and is closing in on its all-time high too. By no means are trade issues inconsequential, but neither is it turning into a disaster as yet.
The bottom line
There are always reasons to worry about markets, but one of the most disingenuous expressions is “it’s never been more uncertain”, because in truth, markets are never, ever certain.
This information is of a general nature only and nothing on this site should be taken as personal financial or investment advice, or a recommendation to buy or sell a particular product.