Collapse aside, warning signs there for stock market ‘retreat’
The chances of a catastrophic stockmarket collapse are remote. But the risk of a sizable “retreat” from today’s overheated markets and plethora of overpriced stocks is high and rising.
The proof that investors have succumbed to “irrational exuberance” once again, so soon after the Wall Street meltdown of 2008-09 and the resulting Great Recession, is too widespread to ignore.
Here are some of the warning signs to consider in assessing the current state of equities. Overvalued markets: The Standard & Poor’s 500, a proxy for the U.S. economy, currently sells at a price-earnings multi- ple (or p/e ratio) of 25.7 times, signalling very high investor expectations of future corporate profits. The S&P 500’s traditional p/e ratio is 15.7.
The Dow Jones industrial average (DJIA) and the tech-focused Nasdaq are also at near-record highs. So are many indices and securities tied to emerging markets, despite upheaval in several offshore economies, including Venezuela, Brazil and the Philippines.
Each of the five major market crashes since 1900 has been preceded by one last bull rally, not unlike the gains this year in a market that was already “fully priced.”
Such markets are said to be “priced to perfection,” because everything must go right to justify unusually high stock prices.
Which makes such markets acutely vulnerable to setbacks.
Eventually the bubble goes looking for a pin to prick it, which could be an attack on Ukraine or North Korea, or the commencement of impeachment proceedings against Donald Trump, or a terrorist attack that takes down a national power grid.
Or it could be Tesla Inc. falling just a tad short of the number of vehicle deliveries Wall Street expected in the firm’s second quarter. Tesla delivered about 22,000 cars. But the Street was expecting 24,000 vehicles. So Tesla stock plunged by 20 per cent, wiping out tens of billions of dollars in shareholder value. Overpriced stocks: Tesla has lots of company among stock-market darlings with astonishingly high price/earnings multiples. Restaurant Brands International Inc. (RBI), the holding company for Tim Hortons, Burger King and the Popeyes chain, boasts a price-earnings ratio (p/e) of 83. That’s much higher than bigger rivals like McDonald’s Corp. (27) and Yum! Brands Inc., owner of the Pizza Hut, Taco Bell and KFC chains (32). Maintaining that high p/e might explain why RBI is accused by irate Tims franchisees of putting cost-cutting ahead of long-term viability.
Shares in investor favourite Canada Goose Holdings Inc., the Ontario-based upscale garment firm, are priced to perfection with an eyepopping p/e of 191. Marijuana producer Canopy Growth Corp., based in Smiths Falls, Ont., has a market cap of $1.4 billion (Canadian) despite no record of profits.
And Netflix Inc.’s p/e of 224 — higher than that of tech peers Apple Inc. (18) and Google parent Alphabet Inc. (33) — is tough to justify given Netflix’s voracious cash consumption and a worrisome debt load poised to grow larger. Rising interest rates: A prime motivator for investors in bidding up stocks since the Great Recession has been equities’ superior return to fixed-income investments. But after a long era of rock-bottom interest rates, central bankers including the Bank of Canada have begun raising interest rates of indicated they soon will.
The higher interest rates from that tightening in monetary policy will draw conservative investors out of equities, now that low-risk securities pay higher yields. That removes a driver of ever higher stock prices.
The “turnaround of monetary policy after a long period of post (Great Recession) accommodation,” according to a Deutsche Bank report this week, “raises the returns on safe assets and lowers the valuation of risk assets.” DB adds that “the U.S. Federal Reserve appears willing to accelerate the frequency of the rate hikes, which could further amply the negative shocks” to equity markets. “Geo-fragility”: The other prime motivator for this year’s run-up in stock prices is the Trump factor. Trumpism promised infrastructure spending of more than $1 trillion (U.S.) and an easing of business regulations.
Reality check: The longevity of a Trump administration under federal investigation is anyone’s guess.
Trump’s infrastructure plan is DOA, since the Republicans who control the legislative branch oppose it. And a new U.S. laxity in regulation, also baked into today’s stock prices, will be thwarted by the same plethora of state governors that recommitted to the Paris Accords on climate change the same day Trump withdrew the U.S. from them.
Unlike investors, America’s CEOs haven’t bought into the false promise of Trumpism. They are, instead, uncertain about America’s immediate economic future. That’s why so many CEOs have stopped providing “guidance” to Wall Street on anticipated corporate performance. Those once routine guidance reports have quietly dropped to a 17-year low. Finally, a note on China: With sluggish growth in Western economies, China is counted on as the greatest source of future corporate profit growth. Expansion in China is factored into the high stock prices at equity markets everywhere.
But China went deeply into debt to finance its Industrial Revolution. Many of its biggest enterprises are effectively insolvent, kept alive by Beijing cash injections.
Beijing warned this week that those state cash infusions will be curbed. The Communist leadership is also insisting that a new caution supplant big dreaming.
The closely monitored People’s Daily, principal mouthpiece of the Chinese leadership, ran a front-page story last week telling the country’s bankers, industrial managers and infrastructure builders to be on guard against “both the ‘black swan,’ but also against the ‘grey rhinoceros,’ all kinds of risk signs cannot be taken lightly.”
Black swans, of course, are unexpected crises. Grey rhinos, a newer term, are obvious problems that are ignored or wished away. An example would be a Chinese banking sector with a massive capital deficiency that Beijing has long chosen to tolerate — until now.
The world’s second-largest economy will continue to be a significant export market for Canada and the world. But hopes of a return to the free-spending China that helped Canada through the worst of the Great Recession before pulling back sharply on state spending would appear to be dashed.
Mind you, even the Cassandras are hedging their bets, by forecasting a stock-market crash two or more years away. This space ventures a crash can be avoided altogether, in place of a 20 per cent or so “correction.”
Ahead of the Great Recession, the central bankers who alone could have prevented it deluded themselves into thinking the markets are self-regulating. Fortunately, today’s central bankers are of a different view. Their corrective measures that will help cool the markets are mightily encouraging.
We might, with luck, be in for a “soft landing.”
Just the same, you might ask why ultrasafe Government of Saskatchewan bonds aren’t part of your portfolio. dolive@thestar.ca