Stockwatch: Further rally, or impending crash?

As the traditionally volatile trading month of October nears, companies analyst Edmond Jackson discusses Professor Robert Shiller's earnings outlook and the likelihood of another recession.

US stocks re-test highs, despite the Federal Reserve removing "accommodative" from its monetary policy guidance, as if a net tightening approach will prevail henceforth.  They are fuelled by strong earnings after President Trump's tax cuts and debt-driven share buybacks near $1 trillion (£0.76 trillion) this year alone, and $4.7 trillion in all since the 2008 crisis. Question now is how long this rarefied market can hold up, or if it will destabilise to affect the rest of us. 

Bank of America asserts: "The bull market is dead"

A notable warning comes from Bank of America Merrill Lynch's (BoAML) strategy team, about how excess liquidity - $12 trillion equivalent in various central bank easing programmes that saw 713 interest rate cuts globally since the 2008 crisis - means the end of excess returns as policy changes.  

The Federal Reserve kept its benchmark interest rate near zero for seven years, inflating its balance sheet (via QE) over $4.5 trillion; the principal reasons why the S&P 500 has soared 335% from 2008 lows.

"Corporates, not consumers or banks, will cause the next recession" given they will need to cut hiring and investment to manage interest charges and reduce debt.  Separately, other analyst firms note how total US business debt as a percentage of GDP is at a record high, the riskiest of borrowers also being the most leveraged.  14% of S&P 500 firms are "zombies" i.e. don't have enough pre-interest/tax profit, to cover interest charges, versus a world average of 10%. 

Buy disruptive technology, pharma and commodity inflation plays…

… so says the BoAML juggernaut.  Yet these hardly feel like conviction ideas.  Most of the tech sector - internationally – is richly rated due to strong corporate narratives and ultra-low interest rates increasing appetite for growth stocks.  They will come under pressure if interest rates rise by much, the market takes a dive, or company news falls short of any stock priced for perfection.  

Similarly, pharmaceuticals usually trade on growth multiples and drug development news is prone to be mercurial.  A return of inflation would boost commodity-related stocks, but unless you engage synthetic exchange-traded funds (ETFs) you are typically looking at miners – which also involve operational risks.   

The nub issue is a current dearth of low-risk financial assets offering worthwhile return after years of ultra-low interest rates.  More realistically perhaps is the extent of cash to hold for near wealth protection and to exploit the next financial crisis – assuming it's short.  BoAML is saying be invested outside the US/Canada - we are relatively well-placed with the London market offering many international companies.

Robert Shiller frets again; "but the market could still go up"

Robert Shiller is the Yale University economics professor who shot to fame, coining the term "Irrational Exuberance" with his book published in March 2000, the peak of the dotcom bubble.  He's since been revered as a guru of financial bubbles if inclined to be circumspect lest his words get pinned down to a prediction.  He's liable to warn about risks as if you should retreat into cash, then add: "but the market could still go up for years".

He's only done this again with a Project Syndicate article and media interview: "Do spectacular earnings justify spectacular US stock prices?"  They are the most expensive globally according to the cyclically adjusted price/earnings (CAPE) Professor Shiller introduced.  His current beef is a public loss of scepticism about corporate earnings.  

True, in the 20 months since Trump took office, earnings have soared by 20% along with stocks up 24% - "as if the market is behaving sensibly, reflecting the US economy's growing strength... But it is important to bear in mind that earnings are highly volatile.  Sudden sharp increases tend to be reversed within a few years.  This has happened dramatically more than a dozen times in US stockmarket history."

Investors should be aware, he says, the difference between revenues and expenses means earnings are inherently more variable: "Rapid growth for a few years can easily be followed by a return to the long-term trend or even subpar levels.  Apparently, investors believe this current boom is going to last... the reason is hard to pin down but must be rooted in a loss of healthy scepticism about corporate earnings.  Talk of an expanding trade war and other possible actions just does not seem strongly linked to talk of earnings forecasts – at least not yet."

He concludes: "A bear market could come without warning or apparent reason, or with the next recession; an outcome hardly assured but would fit with a historical pattern of over-reaction to earnings changes".  

Yet, when interviewed on CNBC, he maintained his image for cognitive dissonance, saying:

"Sometimes I think these are crazy times" but even so "the market could still go up for years."  

What's certain: "This is a risky time, especially investing in the US". 

Will Brexit temper the UK takeover trend?

Expectations for Fed tightening and a positive mood about the US economy have helped a strong dollar; hence, there's also a consensus that US takeovers of UK-listed firms will increase, given the way Brexit is keeping sterling weak and many London-listed firms have international revenue profiles.  

The Bank of England governor appears so worried by Brexit, I wouldn't be surprised if interest rates remain flat this autumn despite the Bank's warning last February of "interest rates to rise sooner and faster than expected".  If the EU and UK do ultimately come to some kind of trading agreement, then now is indeed a good time for buyers to snap up UK firms.

Yet the Labour Party is set to vote down whatever deal the UK might achieve with the EU, and if Tory Remainers also reject any deal – in pursuit of a second referendum – then a constitutional crisis will follow.  As if this isn’t enough to dent business confidence even further, the Labour Party conference struck fear into American bosses about a radical Socialist government, as was put to Theresa May after she addressed a Bloomberg business forum.  

Thus, Brexit chaos and a rising risk it will lead to a Corbyn government, may check appetite for takeovers. 

Heightened risks; where to take cover?

As a proxy for cash, to retain flexibility lest the market dives, ETFs linked to bonds are tending to get promoted to private investors - e.g. with yields to maturity just over 1% for short-dated UK government and corporate bonds, nearer 5% for high-yield bonds.  

Perhaps the chief issue is exactly how liquid such ETFs will prove in volatile markets, if you treat them as a means to park capital.  There’s also the 2008 precedent how all financial assets were hit in a crisis.  

When BBC Radio Four lately brought together leading financial gurus/practitioners, in two separate analyses marking a decade since the 2008 crisis, they took widely differing views as to when would be the next crisis, how long it would last and how deep.  So, don't feel humbled by uncertainty, if maintaining a simple portfolio approach - of sound quality equities and cash.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.