Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 253

Little room for error in equity markets now

The key reason for concern about exposure to equity markets is the over-pricing in much of the market in the US, Europe and UK. The US stock market makes up more than half of the global market capitalisation and what happens in the US echoes around the world.

We have been relatively bullish on US shares since the start of the current ‘Quantitative Easing’ and technology boom, especially stimulated by smart phones, since 2012. It has been a tremendous rally, with the US broad market returning an incredible 140% in the past five years led by tech giants Apple, Amazon, Facebook, Google, Microsoft, and the like. The problem is not profits or dividends as both have been rising strongly during the boom, and the current profit reporting season has seen more double-digit profit growth. The problem is that everybody has come to expect double digit profit growth as the norm, but it is not sustainable and never has been.

Downside risk now dominates

Prices are so high and profit growth so strong that there is now little room for error. We are at a point where there is more downside than upside. The chance of share prices doubling in the next year or so is small, but share prices could easily fall dramatically and languish for years – as they have done several times in the past.

The chart below shows the broad US stock market index in real (inflation-adjusted) terms (blue line) since 1900. The green line shows aggregate annual company earnings (profit) per share across the market. Profits oscillate up and down wildly through booms and busts. The maroon line is the 10-year average real earnings per share. This is much smoother.

Real profit growth (maroon line) has averaged just 2% per year for the past couple of centuries. In that time, America has grown from being an ‘emerging market’ to the largest economy in the world in which its leading companies dominate most industries on the planet. Even in recent decades, real profit growth has still averaged around the same 2% per year.

Click to enlarge

Watch for complacency

Company profits (green line) rise strongly in booms as they are doing now. The problem is that whenever the green profit line rises too far above the maroon trend line as the booms progress, people become complacent and set their expectations too high. They expect double-digit growth to last forever. Whenever boom-time profits reach beyond about 30% above the long-term trend, share prices tend to snap back sharply in sell-offs. The last big sell-off was the 2008-2009 ‘GFC’.

The profit line is currently 30% above its long-term trend and that is on a par with numerous prior booms before sell-offs. So we are in dangerous territory. A further concern is that the current market expectations of profits for the next couple of years (red line on the far-right end of the green profit line) is for further astronomic profit growth, heading into the stratosphere.

For the current tech boom to continue at the same pace as it has been to date, Apple, Amazon, Facebook, Google, Microsoft, etc would need find a new planet, fill it with another 7 billion people and then sell phones, apps and software to them all within the next few years! Elon Musk at Tesla is doing his best, but it will not be quick enough.

 

Ashley Owen is Chief Investment Officer at advisory firm Stanford Brown and The Lunar Group. He is also a Director of Third Link Investment Managers, a fund that supports Australian charities. This article is general information that does not consider the circumstances of any individual.

 

RELATED ARTICLES

US will fall more than Australia in next bust

banner

Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Latest Updates

Strategy

$1 billion and counting: how consultants maximise fees

Despite cutbacks in public service staff, we are spending over a billion dollars a year with five consulting firms. There is little public scrutiny on the value for money. How do consultants decide what to charge?

Investment strategies

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Financial planning

Reducing the $5,300 upfront cost of financial advice

Many financial advisers have left the industry because it costs more to produce advice than is charged as an up-front fee. Advisers are valued by those who use them while the unadvised don’t see the need to pay.

Strategy

Many people misunderstand what life expectancy means

Life expectancy numbers are often interpreted as the likely maximum age of a person but that is incorrect. Here are three reasons why the odds are in favor of people outliving life expectancy estimates.

Investment strategies

Slowing global trade not the threat investors fear

Investors ask whether global supply chains were stretched too far and too complex, and following COVID, is globalisation dead? New research suggests the impact on investment returns will not be as great as feared.

Investment strategies

Wealth doesn’t equal wisdom for 'sophisticated' investors

'Sophisticated' investors can be offered securities without the usual disclosure requirements given to everyday investors, but far more people now qualify than was ever intended. Many are far from sophisticated.

Investment strategies

Is the golden era for active fund managers ending?

Most active fund managers are the beneficiaries of a confluence of favourable events. As future strong returns look challenging, passive is rising and new investors do their own thing, a golden age may be closing.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.