China, The US Stock Market And Overvaluation

CAPE June 2014

By John Richardson

THE US economist, Robert Shiller, has a very good track record in identifying  when bubbles have become inflated. For example, as early as 2003, he foresaw the dangers of the US housing bubble.

And so the blog thinks it is worth listening to him when he warns that:

  • The US stock market looks very expensive, based on his CAPE ratio (cyclically adjusted price-earnings  – see * below for a definition). It is above 25, a level that has been surpassed since 1881 in only three previous periods: the years clustered around 1929, 1999 and 2007. Major market drops followed those peaks.
  • In the last century, the CAPE has fluctuated greatly, yet it has consistently reverted to its historical mean — even if it has taken a while  to do so. Periods of high valuation have tended to be followed eventually by stock-price declines.

Shiller concedes that CAPE isn’t very good at predicting timing, but raises this crucial question:  Are there legitimate factors behind [today’s] high stock prices that might keep them elevated for decades more?

In short, the answer is “No”. Here, we think, is why:

  • Demographics drive demand. This means that the nature and quantity of demand for goods and services are undergoing profound changes in the West as populations age.  We will face economic decline until or unless companies and governments adapt to these changes, and so US stock market valuations bear no relation to the “real economy”.
  • As Shiller points out, America’s hollowed out middle classes understand that something is wrong, even if the demographics crisis hasn’t been recognised. He writes: “I suspect that after the financial crisis, working people are much more worried about their future pay. Many are concerned that they might lose their jobs to cost-cutting, or that they might eventually be replaced by a computer or robot or website. Such anxiety might push them to try to make up for these potential shortfalls by investing in stocks and bonds — even if they worry that these assets are overvalued.”
  • Investors  think that the Fed would never ever risk another Lehman Bros, and so they believe that there is no real downside to stock prices. Logically, therefore, there is nothing to stop them bidding prices up to infinity, especially given that interest rates remain low and liquidity plentiful, despite Fed tapering.

And so what might cause a reversion to Shiller’s historical mean? In  one word again, China.

Most people don’t’  recognise that China’s economic stimulus dwarfs that of the Fed since 2008 – $10 trillion compared with around $3.5 trillion.

As this stimulus is withdrawn in China, there is the potential for another Lehman Bros moment.

*CAPE  uses inflation-adjusted figures to divide stock prices by corporate earnings averaged over the preceding 10 years.  The ratio differs from a conventional price-to-earnings ratio in that it uses 10 years, rather than one year, as the denominator. This minimises the effects of business-cycle fluctuations and so compares valuations over long horizons.