2024-08-17 16:26:00
Nerves and stamina were sorely tested on August 5 and 6, days that culminated a 3-week sell-off that saw global stocks lose $6.4 trillion. dollars from their value. And then morale picked up and the rally started again. It’s not that investors don’t see the risks. What is troubling is how quickly they choose to ignore them.
Stock markets display a spectacular (as well as alarming) ability to move from fears of recession to a climate of (often incomprehensible) euphoria, and from worries about the upheavals that geopolitical turmoil will bring to a curious disregard for all risk. “With fear together and defiance, for the traps, the hatches, the dead ends”, as the poet says.
If there is one indicator that demonstrates the extent to which the rally against macroeconomic and geopolitical data has run its course, it is CAPE. It is essentially the ratio that measures how overvalued or undervalued the stocks are, by the price-to-earnings ratio. This is the index they tend to track more closely than any other as they are interested in long-term investments.
Great Crash levels and…irrational exuberance
At the moment for the shares of the S&P 500 (the most representative index of the American market that also gives a signal to the other major markets around the world) it is at 35 times the average earnings of the last decade. According to data from the Wall Street Journal – on an inflation-adjusted basis – stocks are now more expensive than even 1929 – at their peak just before the Great Crash.
It should also be noted that CAPE had reached the highs of 1929 again in 1997, when the then central banker of the USA, Alan Grispan, had characterized the conditions in the markets as “irrational exuberance”.
The P/E ratio also indicates that stocks are extremely expensive – approaching 2000 levels (just before the dot.com bubble). Some analysts consider this measure less reliable than CAPE since it relies on analysts at major investment banks – whose forecasts could be viewed with a degree of skepticism.
However, whether we calculate the profits of the last decade or those we expect in the next quarters, stocks seem to have lost touch with reality and are flying in the clouds. How did this happen? Partly the frenzy around artificial intelligence that would suddenly take off productivity, part the overconfidence in the “magic wand” of central banks, investors seem to feel that no matter what goes wrong, something will always be there to support them.
The signals sent by the Fed Model
There is one more indicator that traders often use to see if stock valuations are healthy or overpriced.
It’s the so-called Fed Model, which compares the so-called earnings yield (earnings per share to the stock price) with bond yields (ie interest rates). Essentially it is a way of measuring whether stocks are expensive or cheap relative to their safer alternative, government bonds (the comparison is usually made with those of the US).
According to WSJ calculations, stock valuations today are the most expensive (relative to bonds} we’ve seen since 2002.
However, the Fed Model is not infallible. In November 2007 it showed that stocks were at their cheapest levels against bonds since 1985 and therefore represented a great buying opportunity. A month later the subprime loan bubble would burst and a chain reaction would begin that would culminate in 2008 with the collapse of Lehman Brothers and the global financial crisis. It was, in short, the worst possible time to buy stocks instead of government bonds.