Fed Sets Up Risk of Future Dissapointment

FINANCIAL TIMES

15 Mar 2013 4:35pm

Fed sets up risk of future disappointment

By Robin Harding in Washington

It feels almost indecent. This week, the S&P 500 came within two points of an all-time high even though the US unemployment rate is stuck at 7.7 per cent. The mood on Wall Street is still muted. A new record would be one of those that people are not quite sure whether to be proud of, like building the world’s largest shopping mall.
It would not be a record after inflation, of course. But it is worth trying to understand how a moribund economy can produce a soaring market and why it means that stocks are not as cheap as they look.

Analysts put forward several measures to argue that the market is fairly valued, even after its rapid ascent. The simplest is the price of stocks relative to corporate earnings. At 18, the price-to-earnings ratio on the S&P 500 is not especially high and it yields a 2 per cent dividend. That compares with a p/e of more than 40 and a 1 per cent dividend in the year 2000. One reason for that moderate ratio is the exceptional strength of corporate profits – the E in p/e – which are taking a record share of national income. After tax, profits are now close to 10 per cent of gross domestic product compared with 8 per cent before the recession and a postwar average of about 6 per cent.

The flip side of those profits is a record low in the share of national income going to workers as wages. With so many unemployed, workers have little power to bargain for higher wages.

But profits cannot keep growing faster than the economy forever (the limit is 100 per cent of output – at which point all work is done by slaves). Instead, wages should pick up when the economy gets closer to full employment. Historically, profit margins tend to revert to their average and that could mean a period of slower growth in earnings.

Comparing stocks with the dismal yield on bonds is another way to argue that the stock market is cheap. The real yield on 10-year Treasuries, allowing for inflation, is about zero. Buy the S&P 500 and your theoretical share in last year’s earnings returns about 5.5 per cent. That explains why Warren Buffett wanted to turn his cash into ownership of beans ’n’ ketchup maker HJ Heinz.

As US Federal Reserve Chairman Ben Bernanke explained in a recent speech, however, long-term interest rates are low partly because central banks have driven them down by buying assets. If the recovery goes to plan, Mr Bernanke said, “then long-term interest rates would be expected to rise gradually towards more normal levels over the next several years”. The rise in bond yields might be 2 to 3 percentage points between now and 2017. The trauma of the recession is temporary. It does not make the assets of corporate America permanently more valuable. When bond yields eventually rise, stocks will no longer look so cheap by comparison.

The best – although still imperfect – ways to value the stock market do not look at a snapshot of profits such as p/e or compare shares with another asset. They instead try to look at the long-run earning power of companies and the factories, brands or oilfields that they own.

One example is the cyclically adjusted p/e ratio derived by Robert Shiller, the Yale economist known for spotting the internet and housing bubbles. His indicator reads 23.5 compared with a long-run average of 16.5, suggesting that at its new highs the stock market is actually fairly pricey. Another technique is Q – invented by James Tobin – which compares the market value of equities with the replacement value of their assets. Q also suggests that the S&P 500, while not bubbly, is somewhat frothy.

Of course, people have to invest in something and almost all assets look expensive. Given the choice of certain real losses in the short term from holding cash, or zero real returns from holding bonds, eking out some gain from a pricey stock market looks quite tempting. The alternative is to scour the world for the increasingly rare asset classes that people have not caught on to yet.

Mr. Bernanke and the Fed have got their rise in asset prices. It seems to be helping the economy to make progress. But by generating such a strong rally in share prices now, Mr. Bernanke may be setting investors up for years of disappointing returns in the future as the market waits for the economy to catch up.
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