Rate normalcy a concern for stock markets

NEXT week will be the 30th anniversary of Black Monday, a day Wall Street and just about every major stock market crashed.

Panic selling was caused by a number of reported reasons. Programme trading by computers was fingered as the cause of the crash, but another reason why selling gathered pace was valuations of the US markets.

Much has changed from then, but intermittently, there have been bear market corrections in the US stock market that have been, one way or another, linked to an exuberance prior to a major correction.

When Wall Street plunged during the dotcom bust, there was a dotcom boom just prior. And in 2008, the global financial crisis was sparked by an overheating housing market and subsequent bad loans in the US banking system.

The reaction to counter the deflationary pressures from the 2008 crash was to pump liquidity into the system, the amount the likes the world had never seen before. Quantitative easing sent interest rates to historic lows and the US dollar, along with the amount of euros and yen, sloshed through capital markets in search of higher returns.

That hunt for returns meant ploughing money into many asset classes and riskier assets that has led to the creation of super normal asset prices around the world, especially in property in developed markets.

With the US markets now soaring and flirting with fresh peaks, if there is one thing people are generally in agreement with is that stock valuations on Wall Street are expensive on a historical basis.

Even though the rally in the US markets has reached dizzying levels and there is a growing chorus of people who say the markets are overpriced, it is hard to call a sell on a market that has defied past conventional valuation matrices.

Technical indicators for the Dow Jones Industrial Average are super bullish, with a clear buy signal visible when seeing how the index is sitting comfortably above the many different moving averages.

But as stocks in the US are pushing valuations higher and the markets flirt with record levels on a weekly basis, near-zero interest rates and an abundance of liquidity have spurred stocks over a near-decade run few have seen before.

That has created some discomfort among a number of market watchers, with Nobel Prize-winning economist Robert Shiller saying that although valuations are expensive, it has been reported that he thinks market sentiment will continue to defy worries about similarities between now and the period before the Great Depression.

Based on his cyclically adjusted price-to-earnings (CAPE) ratio, current market valuations are worrying. His CAPE ratio is at around 30, which normally is cause for great concern, plus market activity is lower than normal, which has been the case before the market enters a bear market.

Some have said that indicators, based on a historical perspective, do point out that on a host of data, the US stock market’s valuations are very high. In a report last month, equity strategists summarise that, based on previous trends before a bear market, the stock markets in the US are in their final leg up.

But what the market has going for itself is the potential for higher corporate profits should President Trump’s tax plan go through, and also a healthy US economy where unemployment is low and growth rates are up.

“First, it doesn’t make that much sense to try to identify the absolute peak of the market. Partly because if you sell a little bit early, then you are usually in the same position as someone who waits for a bear market to start,” says Goldman Sachs chief global equity strategist Peter Oppenheimer in a report.

Stability in global economies is also helping boost sentiment in global markets. The International Monetary Fund has upgraded its global gross domestic product growth estimate for this year to 3.6% and 3.7% next year, but warns that risks are present.

Higher commodity prices have helped cushion a number of countries and stability in economic growth will help global economic growth.

One risk on the horizon, though, is the return of interest rates towards normalcy. Rising interest rates have usually worked to stem price appreciation and are seen as a negative for stock markets.

As interest rates in the US rise, that will act as another source of concern for stock markets, especially in the US.