Tuesday, April 15th, 2014

An Average Bubble

There is nothing like an equity correction to bring out the bulls in force. The last two weeks have seen a flurry of forecasts for the US market. Some are newly-minted, some are gloriously unchanged by anything that has happened. Here is a quick summary. Consensus earnings for the S&P500 for the next 12 months are $120 (plus or minus), and the target PE multiple is somewhere between 16.0-17.0x, giving a 12-month index target of 1920-2040. At today’s price of 1830, that offers a capital return of 8% in the middle of the range. Add in a dividend yield of 2% and there is apparently very little risk that an investor will lose money in US equities on a 12-month view.

As it happens, we agree with the conclusion, more or less, but we think that some of the reasoning is distinctly flaky. Our main concern is the idea of automatic multiple expansion at this stage of the cycle. One of our favourite websites, seekingalpha.com, has just published an interesting study of the forward PE multiples at the last seven index peaks, excluding the dotcom bubble in 1998-2000. The data goes all the way back to 1958 and includes the current cycle. The average of these seven readings is 16.1x and the range goes from13.2x to 17.7x. This compares with a current forward PE of 15.2x. On the face of it, the consensus target is reasonable, but we remain concerned.

First, there are two readings of 17.7x, both of which come in the Greenspan/Bernanke era when the Fed believed that it did not have duty to prevent asset bubbles. We think the Fed and Congress now understand that clearing up afterwards is a lot more expensive than preventing bubbles in the first place. If we exclude these two data from the sample, the average drops to 15.5x, which implies an index target of 1860 and a gain of 2%.

Second, we are already above the low reading of 13.2x which occurred in the 1982-1990 cycle. There are many differences between that cycle and the current one, but there may be one important similarity. At the beginning of his term, few investors expected Volcker to be so aggressive in squeezing out inflation. We think that Yellen may surprise us with a much tighter squeeze on the use of leverage in financial markets. The Fed has recently announced a leverage ratio of 5% which all major US banks will have to achieve by the end of 2017. In practice all banks will need a margin of safety, which could translate to an actual figure of over 6%. Janet Yellen has also been speaking today about the need for systemically important banks with a small deposit base (i.e. investment banks) to have a higher threshold than 5%, so their eventual target may be more like 7%.

If the Fed wants to continue with accommodative policies for the broad economy, and at the same time prevent another bubble in equities, one of the simplest measures is to require banks to hold more capital. Over time this will lower the inventory of securities they can hold on their books, and reduce their capacity to absorb selling pressure at critical moments in the investment cycle. Risk managers will get worried sooner than they would have done in the last two cycles, which means that the forward PE at the next peak may be below what the historical average says it should be.

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