US economic growth looks like it will remain firm over the next 12 months, but will then begin to slow from its above-trend pace as the economy runs out of spare capacity. Fiscal stimulus, by the time it is eventually enacted, may simply end up pushing up wages, interest rates and the dollar, rather than boosting company profits. And there is compelling evidence that the risks of a recession rise as an economy approaches full employment and begins to overheat, although that usually happens with interest rates a lot higher than where they are now.
US equities have risen by 10 per cent since Donald Trump’s election last November. And Irish equities have risen by the about the same amount. But the sharp rise international equity markets may be due for a pause or even for a short-term reversal. For both equity markets are very richly valued right now. And several short-term sentiment indicators suggest that investors are overly optimistic: in the past, that’s been a reliable signal of poor returns over a 1-3 month horizon.
The most important long-term valuation metric I look at is a national market’s CAPE, or cyclically adjusted price-earnings ratio. It compares the price of a market with its average earnings over the previous decade. Academic research looking back at data as far back as 1881 has established a very clear relationship: the lower a market’s CAPE when it is bought, the higher the subsequent returns over a 10-year period. Both Ireland and the USA currently have CAPE measures above 25. That indicates that they are expensive and, if the past is anything to go by, are likely to generate real annual returns (after allowing for inflation) of only 2-3% over the next decade.
The CAPE is a long-term valuation indicator, rather than a short-term signal. So it would be possible for equity markets to rise by another 10% this year and to then produce even lower returns over the subsequent 10 years and still track the historical pattern. But there are many short-term indicators that equity markets are overbought which suggest that is unlikely.
Investor sentiment in the USA is now extremely optimistic. The current level of 62.7% bulls, 16.7% bears compares to other major market peaks in recent decades as follows: October 2007: 60.2% bulls, 21.5% bears; March 2000: 55.7% bulls, 26.4% bears; August 1987: 60.8% bulls, 19.2% bears. And “complacency reigns” according to BCA Research’s Complacency-Anxiety Index. That suggests that now is a better time to be selling equities than to be buying them.
Cormac Lucey is the Programme Director of the IMI Diploma in Business Finance.
Cormac is also a Financial Services Consultant and Contractor who has previously worked with PricewaterhouseCoopers, Rabobank Frankfurt and the Department of Justice.