Investors have had a strong start to 2017 as global markets moved higher during the first quarter, buoyed by expectations of global reflation and fiscal stimulus that has propelled equity markets higher since the US election last November.
In the US, the S&P 500 increased by 5.5% during the first quarter and the Nasdaq Composite Index advanced by just under 10% over the same period, reflecting continued strong performance from large-cap technology companies and a particularly strong quarter for semiconductor manufacturers.
However, there are a number of variables that should lead investors to question the direction of US equity markets from here.
The first factor that should be considered is the duration of the current bull market. The S&P 500 declined by almost 50% between 2007 and the first quarter of 2009, falling from 1,500 to 800. Over the subsequent eight years, the index has increased by 195% to 2,350.
That length of time places the current bull market among the longest in history, second only to the rally that occurred after the stock-market crash of 1929.
For investors, the further in time that we move away from the pain caused during 2007 and 2008, the more distant the memory is.
However, it would be foolish to believe that stocks can continue to move inexorably higher in a linear fashion.
The second consideration is valuation. The US market looks expensive on several metrics, including price/sales ratios and price/earnings ratios in absolute and cyclically adjusted terms.
The current Shiller’s cyclically adjusted P/E is at 29, higher than in 2007 and has only been surpassed in 1929 and 2000.
Stock markets can stay expensive for an extended period of time, hence the timeless expression from John Maynard Keynes: “The market can stay irrational longer than you can stay solvent”.
For investors, it is nevertheless important to take stock of how expensive or inexpensive the stockmarket is at a point in time as there is a direct correlation between levels of expensiveness and the subsequent annual returns that investors can expect to achieve.
A third, and increasingly relevant factor, are geopolitical events and their respective impacts on stockmarkets.
Chiefly among them is the impact of the Trump administration and the erratic behaviour and decision-making of the US president.
Prior to his election, investors had been fearful of a Trump administration. However, since the election, the stockmarket rallied almost 15%. Supported by hopes of fiscal stimulus and significant reductions of tax rates, investors changed from fearing Trump to feverishly supporting his policy promises.
To date however, Trump has been unable to pass any material legislative changes and has failed to repeal Obamacare despite his political party controlling the two houses of Congress.
The result of this failure is that any hopes of significant taxation cuts are now a lot less likely as the savings from a repeal of Obamacare are no longer available to replace the lower taxation revenue.
There has also been a significant increase in the risk of a military mis-step in the wake of the US missile strike on Syria coupled with increasing sabre rattling against North Korea. Given the alpha-male leadership personalities of the countries that are directly and indirectly involved, the risk of an unwelcome military intervention continues to grow.
Despite the inherent geopolitical risks, volatility levels as measured by the VIX volatility index remain very low and have only started to tick higher in recent days. This is indicative of a market that does not have a significant amount of fear. An environment that is very complacent can be a dangerous one for investors.
A final point to consider is the amount of debt that has been created over the past 10 years, in part used to pull countries out of harsh economic recessions. Between 2006 and 2016, global household, government and corporate debt increased by $70tn (€66tn) to a new record high of $215tn. This is the equivalent to 325% of GDP.
Much of this debt has been created in a time of incredibly low interest rates and, in some cases, interest rates that were negative. However, it is a significant amount of debt that will need to be serviced and almost certainly will attract higher rates of interest as it gets rolled over and extended.
To be clear, there are many US companies that are currently growing and through disruptive business models or through the talent of management, will continue to grow but in aggregate the US equity market looks overpriced and ripe for a correction.
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