BY Bruce Miller, investment director, US equities, at Scottish Widows History warned that a stoc...
BY Bruce Miller, investment director, US equities, at Scottish Widows
History warned that a stock market bubble was brewing in the late 1990s, a bubble that reached its spectacular peak in March 2000. How good it felt towards the end of 1999, when US equities had provided a total return of 27% per year since 1995. As good as it felt in 1999, it was not an appropriate time to buy equities.
Now that we are decisively back in the old economy and 40% below the peak of the S&P 500 index, it feels a whole lot different. A stuttering economic recovery, geopolitical risk of major proportions, eye-popping revelations of creative account- ing and fraud, credit downgrades and prominent bankruptcies make us all a lot less confident of the future. Yet, it is unequivocally better to buy equities now than in 1999 ' how much better, time alone will tell.
Much will depend on how manageable the debt levels are in the economy. Both household debt and corporate debt are at record levels relative to GDP. In the corporate sector, the profit implosion of the past couple of years is sorting out the conservative users of debt from the foolhardy.
What this means for the stock market is surely a steady flow of new equity issuance as corporations recapitalise. Assuming the consumer can stay on track, the next few years are more likely to resemble the early 1990s than the late 1990s as corporations reduce their financial gearing.
From 1991 to 1994, there was net issuance of $185bn of equities and the S&P 500 index provided a total return of about 8% per year. In stark contrast, from 1994 to 2001, some $930bn of equities was retired and the same index provided a total return of about 14% per year.
Right now, with inflation at historic lows, 8% per year would be an attractive return, and is perhaps achievable. The oft-quoted Federal Reserve valuation model, which compares the yield on 10-year Treasury bonds with the consensus earnings estimate for the market, points to the most undervalued equity market relative to bonds since 1980.
The current 25% undervaluation contrasts with a market that was 70% overvalued in early 2000. In case one jumps to the conclusion this is the best buying opportunity in history, another indicator of stock market valuation tells a different story.
In March 2000, the stock market peaked at 172% of nominal GDP, the highest ratio in history. Since then, it has plummeted to a seemingly attractive 105% of GDP, yet this ratio is still above both the 1929 peak of 87% and the 1973 peak of 79%. According to Ned Davis Research, the average level since 1925 is a sobering 57%.
For our final perspective, we return to the aftermath of the 1929 bubble, which had many similarities with the most recent bubble. Although the S&P 500 index fell for four consecutive calendar years, investors with the courage to buy after the first two and a half years of declines, and hold through further gut-wrenching market declines, would have doubled their money within five years.
Perhaps this is the most appropriate, and encouraging, perspective for us all during these uncertain times.
Profits recovery is under way.
Equities look cheap relative to bonds.
Money market fund liquidity supportive.
Increased net issuance of equities.
Market capitalisation to GDP still high.
Household debt levels continue to grow.
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