Are overvalued global equities destined for a crash, as happened in 1987, 2000 and 2007? This scenario is possible but not inevitable.
A 220,000 rise in April jobs triggered a 267 point one-day rise in the Dow Jones index. Chinese A share equities in Shanghai have risen 90 per cent since last summer on People’s Bank of China (PBOC) rate cuts and a speculative retail buying binge. The election of BJP Prime Minister Modi led to a tsunami of offshore institutional buying in Indian equities and debt. European equities have soared to all-time highs after the 25 per cent fall in the Euro/dollar exchange rate since May 2014. Saudi Arabian equities trade at one year highs despite the oil price crash and the Yemen war. Global equities appear to be in a 2007 style asset bubble that could well end in tears. Are overvalued global equities destined for a crash, as in 1987, 2000 and 2007? This scenario is possible but not inevitable.
US equities trade at 17 times earnings. The euphoria of the April payrolls report does not camouflage the ominous implications of King Dollar, pathetic 1Q US economic growth (0.2 per cent GDP), mediocre earnings growth and, above all, an imminent Federal Reserve tightening cycle. The US bull market is six years old. Yet while US equities are overvalued, it is not inevitable that Wall Street will implode in a market crash, as it did on Black Monday (October 1987), the Silicon Valley tech bubble (March 2000) or the post Lehman credit market meltdown (September 2008). Financial engineering, Fed money printing, benign inflation and credible three per cent GDP growth prospects mean US equities, while expensive, are not destined to crash. There are no speculative manias or systemic banking crises on the horizon, as in 1987, 2000 and 2008. The highest risk of the boom bust cycle exists in China’s Shanghai/Shenzhen A share market, not in Wall Street. A stock market crash in China could, of course, send shock waves across the world financial markets. A Greek exit from the Eurozone could also be a disaster for the $12tn GDP EU. An escalation of geopolitical risk in Ukraine and the Middle East could also unnerve financial markets.
Ex energy, US earnings growth is expected to be a mere 6 per cent in the S&P 500 index. This does not support a valuation of 17 times earnings. The US dollar index has corrected six per cent from its 100 level in the US Dollar Index (78 in April 2014). Since one third of the S&P 500 earnings derives from outside the US, the rise in the US dollar acts as a deflationary shock for Corporate America. This means US EPS growth estimates will fall as the US dollar appreciates in the world currency markets. Valuation alone is a poor timing indicator but valuation suggests that US equities offer a poor risk reward calculus at Dow 18,000, S&P 500 2120 and NASDAQ 5000.
The UK general election is hugely positive for London property, sterling and British banks, utilities, energy and construction firms. The Tories under David Cameron need no coalition partner. The resignation of socialist Ed Miliband will force the Labour Party to move to the pro-business consensus politics of the Tony Blair era (1997-2008). London prime property (Kensington, Knightsbridge, Chelsea, Belgravia, Mayfair) hugely benefits from Labour’s defeat and no “Mansion Tax” for homes above Â£2mn. I also expect sterling to rise above 1.62 and the FTSE 250 index to rise another 10 per cent, since it is up 13 per cent for 2015 in any case. The Bank of England will keep its monetary policy accommodative as long as Chancellor Osborne maintains his pledges on deficit reduction and pro-growth economic policies.
As I expect the Euro/dollar rate to fall to 1.06 by year end 2015 on relative growth/interest rate differentials between the EU and the US, I believe it makes strategic sense to buy German auto exporters, the most obvious beneficiaries of the Euro’s fall. My other investment thesis is to buy undervalued, restructuring banks such as HSBC or even RBS and Lloyds, which will be privatized by Chancellor Osborne. The Stoxx Europe 600 is no longer cheap at 16.6 times earnings or a price/book value above 2. However, as long as ECB President Draghi buys â‚¬60bn a month in European bonds, the valuations in the Old World can be justified since the implied equity risk premium is still above 7.2 per cent, thanks to centuries low government bond yields. This is not a “bubble” market.
In Asia, I believe Japanese equities will retain their bullish momentum since the Bank of Japan will offset deflation risk by another “shock and awe” QE announcement, pension funds and life insurers increase equity allocations and structural reform (the third arrow of Abenomics) increases. The Nikkei trades near 20,000 but is still not overvalued at 15.4 times earnings and 1.6 times book value. While expensive, Japan is no bubble.
The recent 2000 point correction in the Sensex and the Nifty near 8200 creates value in Indian equities. We saw a 10 per cent correction in Dalal Street since Indian equities indices peaked in mid March. Awful earnings in IT services (blame the weak Euro), a weaker rupee, FII selling and the surge in crude oil in April were all factors that led to the selloff in Indian equities. India has been the “consensus overweight” of emerging markets funds since the election of the reformist BJP government last summer so it is not surprising to see profit taking. MSCI India trades at 16.4 times earnings and three times price/book. This is hardly a “bubble” for a market where the cost of equity is coming down (RBI rate cuts) and the returns on equity is rising (Modi reforms, disinflation). Among global markets, only China is in an asset bubble. However, the economist Keynes warned us that “markets can stay irrational a lot longer than you can stay solvent”.