Can the share market carry the economy?

Some very smart pundits like to say that stock markets don’t discount recoveries, they create them. As the ASX rushes higher is that in prospect for Australia?

In some ways, yes. The rally is already spreading a wealth effect, playing some kind of a role in lifting the spirits of consumers as super balances swell for the first time on four years. Next up there is sure to be a rally in the top-end of the property market which has a high correlation with share market returns, as the AFR explores today:

Volumes and buyer interest at the top end of the property market are starting to move, as the sharemarket rallies and interest rates remain at historical lows.

The S&P/ASX 200 surged through the 5000 point barrier last week and observers are expecting a kick in the prestige property market, particularly on Australia’s east coast, as it is highly correlated with the sharemarket.

This is partly due to the residential market’s dependence on the bonuses generated in the financial services industry and also because of the sharemarket being a barometer of confidence.

To the extent that upper-end property has an out-sized impact upon house price indexes, the recovery such as it is will lend more confidence to the wider housing market as well.

Through the first half of this year this could erode the rock solid post-GFC national savings rate that has been evident since 2008 and boost retail sales at the margin. I do not expect a sudden collapse in savings. But even a small shift will be felt in activity.

Perhaps this might also lead to a small uptick in investment in consumer facing sectors but that will take time and with such a high dollar remains doubtful.

And therein lies the problem. We know that an end to the mining investment boom is nigh. The RBA sees it happening right now. Most private forecasters, including me, see it mid year. A few at the end of the year. Estimates vary too on the pace of the decline but all see it weighing heavily on growth, especially nominal growth as the terms of trade boom bleeds away as well. 

The battle, then, for the stock market is whether it can hold its soaring valuations in the face of mediocre earnings growth. If the Australian economy can rebound to nominal growth of 5% and real growth of 2.5% for the next twelve months (which is more than fair!) then where will that leave stocks? As a bourse, how is the ASX going to grow faster than nominal GDP?

Here are the key valuation metrics for the ASX200 at yesterday’s close (not that valuations are driving the rally but it gives us a benchmark):

So, we’re now trading on forward price/earnings ratio of 20. That’s the richest mid-cycle  valuation in living memory:

It says a lot that at no time during the 2003-2007 bull market did valuations get this stretched. Indeed, the only times forward price/earnings have been higher is during recession conditions when the bourse is discounting a recovery amid wholesale write-offs.

You might argue with some justification that we’re not mid-cycle, given late last year much of the world was in recession. For Australia, much of the economy has been stalled or in recession as well to make way for mining and adjust its external debt. Is this not just another reflation rally?

Perhaps. But such analysis is born of past cycles of monetarist booms and Keynesian recoveries. This time Australia is only part way into a structural adjustment that restricts economic growth largely to internal funding even as mining investment winds down. To the extent that the share market rally causes a fall in the savings rate it may exacerbate the funding challenge. With these restrictions, current estimates for aggregate earnings growth of 25% or more over the next two years are, in a word, delusional.

That means that even accounting for some extra premium born of financial repression, the bourse is already looking very rich.

That is not to say that it’s all about to end. We’re clearly twirling towards freedom on the benefits of financial repression. I expect as the year gets older and mining investment weakens that the pressure on shares will increase. But this will be offset by upward pressure on valuations from rate cuts and a falling dollar.

Can the bourse carry the economy alone? It’s a lot to ask.

Houses and Holes
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Comments

  1. The share market risk (All Ords, based on Yahoo free data since 1984) is relatively high at present with 2 month growth being at the 93rd percentile.

    1 year growth is at the 75th percentile and if the market remained unchanged (5056)until 26/6/2013 1 year growth would be in the 86th percentile.

    The market only grows this fast or faster for 7% of the time (2 month growth) and 25% of the time (1 year growth).

    While on longer term measures growth is at much lower percentiles, a correction or consolidation in the near future is to a relatively high probability.

  2. Ah yes, the wealth effect, the belief that rising asset prices beget confidence which begets borrowing and spending, which somehow expands the productive capacity of an economy. The wealth defect, I prefer to call it.

  3. John Hussman’s latest “The Siren’s Song of the Unfinished Half-Cycle” makes the point that the US market has characteristics that suggest it is in a range where bear markets normally start and that the average bear market is a 32% fall (32/100)

    I note that a 32% fall from the top (100-32 = 68) would wipe out a gain of about 47% from current values (32/68=47%). Alternatively 100 now, 147 at top, 32% fall from 147 is 147 – (147*0.32) = 147-47 = 100), 100 to 147 is 47% gain.

    He recommends ensuring that you know how you are going to get out and refers to the mythology of Siren song as a measure of how being seduced by failing to examine markets on the basis of complete cycles and instead using arbitrary periods like 10 or 4 years that represented inclusion of part completed cycles. He notes the extreme discipline needed to listen to the Siren song (being tied to the mast by a crew who can’t hear the Siren song). He also notes the problem of whipsawing.

    He also talks about the identity for GDP and how high government deficits and low wages share support the current very high profits level, share of GDP and relationship to Shiller’s 10 year average earnings.

    While he missed the 2009 recovery largely because he didn’t anticipate the amount of fiscal and monetary/interest rate stimulus, he has a very data driven approach.

    The question he doesn’t consider is whether the US has entered a new, long lasting regime of very low interest rates and a higher market and it truly is different this time. He assumes the cycle will turn as it generally does, based on mean reversion of markets, earnings, PE’s, deficits, interest rates, wage share of GDP.

    http://www.hussmanfunds.com/wmc/wmc130218.htm

  4. Let’s face it. Nobody knows whether the currently rally is a new secular bull or an illusory cyclical one.

    Waiting to find out, on a cash return of 1% above inflation is hard work.

    Patience has its risks. But impatience at current levels can be riskier.

  5. kristian.schmidt

    No, stocks cannot, but housing can carry the economy 😉

    No, wait, tulips can…no, wait, stocks in the Mississippi Company can…no, wait, free money for the state can…

    As per the Tulip Mania, the tulip price cannot make the economy grow healthily. But it will certainly send it into overall recession if pricing and price induced resource allocation is way off from reality of human needs, wants and abilities (HNWA).

    The stock market is, amo, people pricing a long bet on future earnings and earnings are derived from getting the value supply chain right; the value chain that is based on HNWA. You cannot make earnings go up by betting that they will. Prices must be a true representation of HNWA (that includes the price of time and resources, the interest rate). And also, like in China, earnings are not correlated with high activity (GDP or was is mistakenly called The Economy).

    Known stock bubbles indicate the opposite of the so-called wealth effect; with the Mississippi bubble as the greatest example. Bubbles, such as priming the stock market to create a false feeling of wealth for stock-owners and their creditors, lead to recession or, with extra effort, to depression.

    Prices, those of stocks too, have to represent true expectations and not a desperate positioning of money in a low-yield environment.