ONE of the most important questions facing investors is what to make of the rebound in asset prices and especially equities. With the economy and profits starting to recover, much of the resurgence is clearly attributable to improved fundamentals. But some of the newfound optimism is also being driven by the vast amounts of liquidity still being injected into the system by central banks and is therefore not truly sustainable. Telling one factor from the other is tough; the good news is that in the case of the US, much, if not all, of the recent recovery in equities is justified. The UK case is harder to gauge, however, and I will return to it in future columns.
First, a bit of history. The price to earnings (p/e) ratio on US stocks hit a recent high of 27.5 times in May 2007, collapsing to 13.3 in March this year at the trough of the downturn. This was the lowest valuation for a long time, though it was nothing like as bad as the 8.2 registered in 1982, just before the Reagan revolution started to bite and America bounced back. It is easy to forget how awful the world looked at the start of the 1980s; the previous 15 years had almost finished off the West and were arguably more painful that what we’ve just been through.
The market recovery of the past few months has taken the US p/e back to 18.77 today, according to the smoothed 10-year index calculated by Robert Shiller, the Yale economist. The average p/e between 1928 and 2009 was 17.4 . Whether or not the current level is fair, slightly too high or slightly too low is unclear - but we are not back in bubble territory. The market reached 44.2 at the height of the previous bubble in December 1999. After a sharp fall the market remained at relatively elevated levels before sliding down to 21.21 by February 2003. It then rose back and remained roughly in the 24-27 range for the next few years until the second bubble burst.
All of this suggests two things: stock prices did not fall back enough after the dot.com bubble burst; and while the US was trading at excessively high levels over the past five years – partly as a result of gains in financial and real estate firms, and because of the leverage buy-out epidemic – it never reached anything like the crazy late-1990s levels. The bulk of the excess liquidity went into property (which subsequently crashed and is now back to normal) and into credit markets (which remain all over the place).
For while equities and property are now fine, the dollar and US Treasuries are still both being propped up artificially by the fact that central banks the world over like to hold dollars. Even though the US currency has slumped 15 per cent in recent months on a trade-weighted basis, there is still clearly a bubble in greenbacks. The only way to deflate it gently would be for American consumers to save more and spend less, and for the government to live within its means. For the sake of global stability, we must hope that both see sense – and that the readjustment happens smoothly.
So HSBC’sCEO Mike Geoghegan will now be based in Hong Kong rather than Canary Wharf. This is bad news for London:the world’s centre of gravity is moving East. But the real tragedy, judging from his latest anti-City rant yesterday, is that Gordon Brown wants to accelerate this power shift. Our loss will be Asia’s gain – but that’s the madness of populist politics for you.