In late July, the small cap stocks in the US did not follow their larger brethren to new highs, which is called divergence. Divergence along with overvaluation and bullish enthusiasm are signals of a potential sell off. Is that happening now?
Was last week's sell-off the first sign of a bubble deflating or just a temporary pull back? There is no way to really tell with certainty. There is reason to worry though, even the Chairman of the US Federal Reserve has noted, that certain sectors of the equities market are “over stretched”. Meanwhile, the financial press in the US and the UK have their own bubble of writing about bubbles. They have been writing more stories that include the word “bubble”, over the past 18 months than ever before. And there is certainly a lot to write about.
Let's start with equities. During the dotcom boom, the boom was largely localized in dotcoms, hence the name. But in the US today, the entire market has high valuations. The cyclically adjusted price/earnings ratio (CAPE) is 60% above its 130 year average. The Q ratio (Tobin’s Q) one of the most accurate means of valuing equities markets has been higher only in 1929 and 1999. The percentage of profits of US GDP always reverts to mean. As of now, it is at levels seen after the second world war. Not just the US, but almost every other market everywhere, is close to or already at highs, despite some slowing growth. Brazil’s market is only 5% off its all time high, but growth has been slowing since 2010.
Then, there are the bonds, really almost too many to mention. There are junk bonds, which have been at record low yields. Then there are the bonds of peripheral Europe. For example, Spain received bailouts and has a credit rating, which is 7 levels below the US, but pays the same interest. The rest, including Ireland, Italy, and Portugal also pay relatively low yields.
Don’t forget emerging market sovereign debt. Argentina is really not worth mentioning, but there are ten other countries including Greece, Ukraine, Pakistan, Ecuador, Venezuela, Belize, Egypt, Cuba, Cyprus, and Jamaica with credit ratings below Moody’s 'Caa' rating, which is considered to be either highly speculative or with extreme risks. Other lending to emerging markets is also at a record high. Corporate debt in emerging markets has expanded far more than any other asset class, 500% since 2008.
It is not just corporations and governments that have gone deeply into debt. There may not be as many subprime home mortgages these days, but there are quite a few subprime auto loans. Sales of subprime auto loans in the US are the highest since 2007. About a third of new car sales are subprime and so are two thirds of used car loans. Like the mortgages before them, these loans are securitised and sold on to insurance companies, mutual funds and pension funds. Spending on cars is extremely important in the US. If you discount car sales, retail consumer sales would have contracted in the first half of the year.
Consumer debt is not just an American problem. Consumer debt burdens in Asia are up to 30% higher than in the US. The countries affected include India, Indonesia, Thailand, South Korea, China and Malaysia. There are also potential real estate bubbles in London, China, Hong Kong, Sydney Australia, Canada, and Brazil.
But the problem with bubbles is that it is a matter of personal taste. One person’s bubble is another person’s healthy exuberance. According to legendary investment sage, Jeremy Grantham, a bubble is when prices are two standard deviations above norm. Large bubbles that fit that definition occur once every 31 years. The US market does not quite fit this definition, but Mr Grantham also identified 330 minor bubbles. Only 30 of these did not burst, at least so far, and all were in obscure assets. However if you look at corporate profits alone, the situation right now, easily falls within the definition.
Recently, the chief economist of the Bank for International Settlements (BIS), also known as the central bankers’ central bank, issued a warning. He said that there were dangerous imbalances building up in the financial system. Of course his predecessor had said the same thing in 2003. Although he was right, it took another five years before the bubble burst. The level of debt compared to 2003 is exponentially higher as is almost every asset class.
Janet Yellen, Chairperson of the Fed, believes that interest rates should not be used to control bubbles. She feels that she can use regulations or “macro-prudential policy” to ensure there is no crash. The BIS is appropriately sceptical about this as well. We must remember that Ben Bernanke, the creator of the present massive bond buying program QE, told us before the crash that the subprime mortgage loan problem was “contained”. It wasn’t.
There is one thing about the present market that we do know, at least for the moment. The US Federal Reserve’s program called quantitative easing is ending. So the era of unlimited cheap money will eventually come to an end. Recently, junk bonds have started to sell off. They have been rising for nine consecutive months breaking a record set in 2007. This time a sell off will likely be more of a problem due to the lower liquidity.
There is also something else, which is troubling. The small cap stocks in the US did not follow their larger brethren to new highs in late July. This is known as divergence. Divergence along with overvaluation and levels of bullish enthusiasm are signals of a potential sell off. Is that happening now? We shall see, but we do know that it will happen.
is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and speaks four languages.)