Conventional valuation criteria show the US equity market is more expensively rated than at any time...
Conventional valuation criteria show the US equity market is more expensively rated than at any time in modern history. This raises several issues, the main one being whether such an extraordinary period of stock market activity can be expected to last for much longer.
Will those who called the top of the market back in 1996 or 1997 or 1998 be vindicated finally by a bear market of mighty proportions? More to the point is whether there has been a fundamental change in the equity market?
Conventional valuation criteria, which have been relied upon traditionally as a guide to timing entry and exit or buying and selling, have proved to be so ineffective this time round. Is it because valuation no longer matters? Did it ever?
Although the US equity market is more expensive now than at any time in the post-war period, it was also more expensive than at any time in the post-war period three years ago.
Indeed, on the basis of the dividend yield, one could even have made this very comment at the start of 1995 when the most recent phase of the bull market began.
Since then the equity market, as measured by the S&P500 index, has nearly trebled in value. The bears have missed out on an opportunity of a lifetime.
Are they now about to be vindicated? No doubt they will - but just not yet! The worry is not that there will be a sizeable correction for a market which has performed extraordinarily well but that a secular bear market will develop of the proportions seen when valuations have been so extended in the past (the most recent example being in Japan).
If the secular trend remains one of disinflation, the secular trend for bond yields will still be downward and the tendency for the earnings surprises to be positive will persist.
The combination will be fundamentally supportive for equities and means the secular bull market can be sustained. Furthermore, the tendency for the equity market to look expensive in a disinflationary regime will remain more apparent than real.
This is not to say that corrections or setbacks will not occur. Throughout the long bull market which has been established since the early 1980s, corrections have occurred frequently. But the lesson has been that periods of consolidation or setbacks present long-term buying opportunities.
The real issue is whether a new secular trend is developing. Yields in the US bond market have been rising for nearly a year. Is this the harbinger of that change in secular trend or response to emerging short-term cyclical pressures on inflation?
There are grounds for believing that the bond market is responding only to short-term cyclical pressures. Economic growth is failing to slow down meaningfully in the US.
Meanwhile, activity is picking up in Asia and Europe so the prospects for US exporters are improving.
The softening of the dollar merely enhances the competitive position of S exporters.
All this is coming at a time when the economy is very nearly fully employed. There is plenty of unused manufacturing capacity but the labour market is tight. In addition to this, oil prices have more than doubled from their low point at the turn of the year.
The production restraint which Opec has applied was well timed (from Opec's point of view) in the sense that it coincided with the change in sentiment on the prospects for world growth. However, while rising energy prices have pushed up the headline inflation rate, the underlying or core rate has actually been decelerating.
Nevertheless, the Fed is unlikely to take any risk with inflation. In all probability the newsflow will continue to point a stronger than expected economy and the Fed is likely to respond by continuing to tighten policy.
So, if in the short run, interest rates are heading higher and the bond market remains apprehensive about the Fed's intentions, then the equity market may struggle and there may be periodic corrections. But this is not to say that the bull market and the secular trend towards low inflation and/or disinflation is ending. The case for disinflation rests on structural rather than on cyclical considerations. The case in point is the high tech revolution, an innovation which has spawned investment by both firms and consumers alike in information and communication technology (ICT).
It has yet to be proved that ICT is raising the productivity of the US economy and enabling a higher non-inflationary rate growth to be achieved than has hitherto been available to the economy in the post-war period. But investment in ICT is lowering prices and helping to create a frictionless economy.
In this world of near perfect information, costly intermediation is becoming redundant. E-commerce is flourishing. These features, in combination with the productivity enhancement that may be attributable to the high tech revolution, is reinforcing the secular trend of disinflation to the benefit of the consumer.
Although the evidence has yet to support the view that investment in ICT is both raising growth and lowering inflation, the evidence suggests that it could be happening. Disinflation is associated with faster GDP growth and the high tech revolution may be the external factor which is helping to generate both.
Unfortunately, it cannot be put more strongly than this for as the Economist noted in a recent edition (24 July 1999) the position seems to have given rise to a productivity paradox which has been aptly summed up in the now familiar quip of Robert Solow, the Nobel laureate in economics: "you can see the computer age everywhere these days except in the productivity statistics".
However, what is apparent is the significant shift in the balance of pricing power away from the producer and toward the consumer.
This shift is a manifestation of underlying disinflationary pressures. Producers have been resp
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