Bubble, Bubble, Timing, Trouble?

There has been much speculation in the media of late regarding asset prices across most sectors.
Is the Sydney-city property market too hot? Are equities overvalued? Why is the US share market at all-time highs?

Inevitably ‘asset bubbles’ happen in every economic cycle. The challenge for investors is not only to have the courage to invest in an asset when it is under-valued but also to have the courage to walk away from an investment when it is beyond fair value.

This all sounds very logical until we introduce emotion. Generally, we are most inclined to invest when the economy is good and the world is full of good news and least likely to invest when the world is full of doom and all seems lost.

After 16 months of stellar returns in most markets, it is important to ask whether or not shares are over-valued. There are numerous ways to gauge the valuation of a market. If we were to look at just two, they would be the ‘price/earnings ratio’ (‘PE’) and the level of corporate profitability relative to the broader economy. By either of these measures the US economy looks very expensive. Its PE is currently 18 times, up from 14 times just 18 months ago. On top of this, US company profitability as a proportion of the economy is at an all-time high. Never have shareholders enjoyed better returns whilst workers have suffered such stagnant incomes.

Given that profit margins are cyclical and will inevitably revert to the mean, we are concerned about the current level of the US market.

The Australian market on the other hand is at a PE of 16 times which is only marginally above historical averages and company earnings have been relatively flat since 2007; in other words, there is room to grow, ‘adding some E to the P’.

Another bellwether for market valuations is debt.  Unfortunately people usually want to borrow to buy shares at the wrong end of the cycle. In the US, margin loans have returned to 2007 levels which is very troubling. The opposite is true in Australia where margin loans continue to be shunned as we squirrel away our savings and continue to repay our home loans.

It is also interesting to understand the impact that fear has on markets. Historically people have been prepared to pay for options to protect their portfolios when they fear there is likely to be a sell-off. This option activity (fear) peaked in late 2008 with the collapse of Lehman Bros. Disturbingly, there is very little option activity in the market at the moment suggesting that people do not fear a correction. This could be a sign that the market is becoming complacent. Nervous markets are often cheaper to invest in.

Another signal that we are nearing the end of the cycle is product innovation and new listing (‘IPO’) activity.

As markets run to their top, product designers create convoluted products to attract a new wave of investors seeking something sexy on the understanding that ‘things will be different this time’. All too often they’re not, and these products disappoint. This has not happened so far in this cycle and we believe that it is unlikely that this Bull Run will end before a new wave of financial engineering has experimented on investment guinea pigs.

The other side of this story is IPO activity. Whilst there’s been very little on this front for the last five years there has been a wave of new listings in recent months taking advantage of our new-found confidence.

In summary, we say “proceed with caution”. Markets would appear to be somewhat over-valued at present and some type of pull-back would not be surprising. This is not a new phenomenon; it happens at some stage of every market cycle. Typically markets over-shoot at the top end of a cycle with over-exuberance and similarly over-correct at the bottom end.

At present markets are experiencing a greater than normal degree of volatility as we await the potential impact of the anticipated tapering of the quantitative easing (‘QE3’) program in the US. Markets are concerned that this expected tapering may have a negative impact on the recovering US economy.

As we believe that there are no long-term tangible benefits to be gained by ‘market timing’, we are not advocating changes to client portfolios, unless there has been changes to client objectives, time-frames or circumstances. As always, we will remain alert to market and economic conditions and will recommend changes as required.