Stock markets in the US have hit record highs in recent days. With the Dow seemingly making new highs regularly. This is happening at a time when many believe that share prices are on high valuations and may be fully valued, so should we be looking for a reversal of the index?
Since 2009 at the height of the financial crisis the Dow has risen from its lows in March of 6,589 to its current level of around 17,000. Much of this has been fuelled by an era of easy money via the Federal Reserve’s Quantitative Easing programme and low interest rate policy. The hunt for yield resulting from this easy money has forced investors to take on more risk and buy shares where yields have been considerably higher than that which can be obtained in ‘safer’ fixed interest investments.
It has not just been a hunt for yield that has driven shares higher. During the crisis most companies put their balance sheets in order, refinanced their debts at much lower interest rates, used positive cash flows to reduce debt and forced through lower costs in their operations. The result of these actions has been that profit margin falls were limited during the slowdown and small increases in revenue came through to profits more quickly. Signs of a recovery led investors to anticipate that revenue increases would pick up and that these newly efficient companies would see profits rise sharply. Valuations of shares rose to reflect this optimistic view.
On May 22nd 2013 the Chairman of the Federal Reserve, at the time, Mr Ben Bernanke, warned that the Federal Open Market Committee (FOMC) were considering reducing the rate of which they pumped fresh money into the markets. The prospect of greatly reduced liquidity very quickly took the froth off the market and some high valuations were reduced sharply. It also affected the level of interest rates as markets acted before the liquidity dried up and this in turn caused some weakness in the US mortgage market. Since the recovery still relied on strong consumer spending and confidence this put the recovery at risk and the FOMC delayed any decision to reduce the rate of quantitative easing. Perhaps, as Mr Bernanke was near the end of his term of office the tapering of financial easing did not take place until his successor Janet Yellen had been announced. Tapering was started at the end of 2013 and has continued since at a rate of $10 billion per FOMC meeting and is expected to be completed by the time of the meeting in October 2014 with a final reduction of $15 billion at that time.
The Federal Reserve are very keen to bring financial management back to normal but are equally very keen to embed the recovery firmly. The hesitant levels of growth seen this year imply that there is still a long way to go for a strong recovery to be seen. The FOMC is keen to stress that, even when quantitative easing has been completed, interest rates will stay low until such time as the recovery becomes clearer. Evidence for the recovery will be seen in higher wages, lower unemployment but most importantly with an increase in business investment.
Ahead of tapering share prices may have got ahead of themselves and valuations became stretched but so far this year earnings have continued to expand albeit slowly. This has happened even though there was a sharp slowdown at the beginning of the year due to severe weather.
There are no clear signs of stress in the economy and companies remain cautious. Companies are not getting carried away with their prospects and remain slow to expand activities. There are, however, signs of some confidence reflected in the increase there has been in mergers and acquisitions, although some of those are so that the company can take advantage of lower tax regimes, the majority are for better strategic reasons. Inflation remains low and money growth does not imply an inflationary tendency. Spare capacity remains at high levels at under 80% with closer to 87% being regarded as full capacity so that there remains significant room for expansion of economic activity. GDP growth may have risen to where it was before the crisis but still has a long way to go to reach where it should be some five years later. So there seems to be plenty of room for optimism that the recovery could have some way to go.
Growth in America will be driven by SMEs (small and medium size) companies but large companies are also benefitting from a small but discernible recovery in Europe and a continuation of growth in China. These two areas have been a considerable concern for global investors but it is beginning to look as though the worries are unwinding. It is true that Europe remains a large problem and concerns have not been clarified regarding China but the authorities in each economy continue to seek growth that is appropriate to their objectives.
The unwinding of liquidity through tapering was expected to harm emerging markets as spare funds were withdrawn from the sector to repatriate to the US where returns may be expected to be higher and safer. This impact has been much less than was feared and confidence in a global recovery is slowly recovering.
There are many who believe that we are on the verge of a major long term bull market in equities and that once tapering has been completed the economy can move forward again. At the moment the recovery is driven by increased consumer spending fuelled by rising debt. This is the very thing that led to the crisis in the first place and cannot be encouraged, however, central bankers, including the Federal Reserve are taking the view that these problems can be controlled without the use of higher interest rates and that controls on lending and other regulatory measures are the best way forward. If they are right, then interest rates may rise when the economy is stronger but may not have to go up far. Interest rate increases will hit spending very quickly as consumer debts remain high so it is very believable that rates could stay low.
There is no justification yet for analysts to forecast much higher revenues and profits but the basis is there for that to happen. Markets’ climb a wall of worry’ in a recovery and the time to be concerned is when investors stop worrying and become euphoric. We do not appear to be there yet.
