As the US market starts to look rocky it is worth remembering that the rise over the last couple of years has been strong. The report by Prudential to which I referred on the weekend had some interesting insights into share valuations in America. It is not being driven by sentiment, it is being driven by profit growth. The financial health of corporate America, outside the financial sector, is good, especially given the GFC. It seems corporate America, unlike America’s economically struggling citizenry. saw the GFC coming. They are now playing globally, in effect bypassing over exposure to the US domestic market. Apart from the obvious political implications of that — the breakdown of the domestic compact with workers/consumers — it has implications for share valuation. As the Prudential report says, it is very unusual:
Profits Versus Valuation – The most rapid 2-year rise in equity prices since 1936 has been fueled primarily by expanding earnings per share (EPS) rather than by expanding equity market valuations. The roughly 100% gain in the equity market since March of 2009 can be attributed to a record cumulative 75% rise in EPS along with a 25% expansion in equity market price-earnings (P/E) multiples.
Unusual Pattern – This percentage breakdown is unique in the context of early cycle equity bull markets of recent decades, in which a majority of market gains were attributable to rising market valuations, and a smaller amount to profit growth.
Two factors account for the current unusual pattern: (1) The unprecedented magnitude of the rebound in corporate earnings over the past two years; and (2) Lingering economic and financial risks in the aftermath of the worst recession since the 1930s, which have resulted in a sharp increase in the equity risk premium (ERP). An elevated equity risk premium manifests itself in constrained P/E multiples.
To summarize, the current economic cycle is highly unique and unlike any of the nine previous business cycles of the past six decades. The central theme is the massive and widespread breakdown of the financial system and collapse of the credit creation process, which has devastated the real economy. Although credit conditions are slowly improving, restoration of a normal functioning financial system is still several years into the future. Consequently, lingering ripple effects of the economic crisis could be felt for years as key sectors of the U.S. economy undergo a protracted rehabilitation and healing process in a gradual return to normal.
This suggests that money, despite being unusually cheap in America, is tight. Tight in debt and tight in equities. As Japan’s two decades of recession has showed, when confidence collapses, the effectiveness of monetary policy is limited. You can give it away almost free and it has little effect.
I think there is another implication. The business growth may be in the emerging world, but the financial maturity of the emerging world is still poor, especially in China. When big corporates are simply producing their products in China, Eastern Europe, India then marketing back to Western domestic consumers, then that is not a problem. It is simply a matter of shipping between the two countries.
But domestic consumer demand in Western developed economies and Japan is in real trouble. When the big Western corporations start to rely for their profit growth on selling to consumers in foreign markets, then the financial sophistication and openness of those foreign markets comes into play. Especially if that market is in China, which is far from open and which is still fixed on the capital account.
What the US stock market may be telling us with its unusual behaviours, is that the centre of the world is shifting inexorably to developing world, especially China and India. That has lasting implications for investment.