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By Satyajit Das at MarketWatch
The mispricing of assets across world markets has reached epidemic proportions.
Stock prices have made strong advances over the past several years, yet market analysts see further gains, arguing that the selloffs of August 2015 and early 2016 represent a healthy correction.
But this rise in stock values has been underpinned by financial engineering and liquidity — setting the stage for a global financial crisis rivaling 2008 and early 2009.
The conditions for a crisis are now firmly established: overvaluation of financial assets; significant leverage; persistent low-growth and deflation; excessive risk taking reliant on central banks for liquidity, and the suppression of volatility.
For example, U.S. stock buybacks have reached 2007 levels and are running at around $500 billion annually. When dividends are included, companies are returning around $1 trillion annually to shareholders, close to 90% of earnings. Additional factors affecting share prices are mergers and acquisitions activity and also activist hedge funds, which have forced returns of capital or corporate restructures.
The major driver of stock prices is liquidity, in the form of zero interest rates and quantitative easing.
To be sure, stronger earnings have supported stocks. But on average, 70% to 80% of the improvement has come from cost-cutting, not revenue growth. Since mid-2014, corporate profit margins have stagnated and may even be declining.
A key factor is currency volatility. The strong U.S. dollar DXY, +0.01% is pressuring American corporate earnings. A 10% rise in the value of the dollar equates to a 4%-5% percent decline in earnings. Rallies in European and Japanese stocks have been driven, in part, by the fall in the value of the euro EURUSD, +0.1089% and yenUSDJPY, +0.48% respectively. Lower commodity prices, especially in the energy sector, affects resource firms’ earnings. In the U.S., wage increases may also erode profit margins. The major concern is weak global demand, with lackluster growth in Europe and Japan and deterioration in emerging markets.
The lack of revenue improvement and deceleration in earnings growth mean that recent price increases reflect high price/earnings and price/ book ratios. The S&P 500 SPX, +0.18% now trades at around 17-18 times forward earnings, a level that is historically expensive and only exceeded during the 1999-2000 tech-stock bubble. Other markets are also priced above historical levels.
The frothy environment is also evident in other investor behaviors. Investors chasing revenue and earnings growth have pushed up valuations, while more than 80% of new initial public offerings were for companies with no earnings. A significant component of activity has been private equity investors taking advantage of high valuations to sell holdings.
Other asset classes show similar stresses. Government bonds around the world, unless distressed such as Greece, Ukraine, or Venezuela, trade at artificially low rates. More than $7 trillion of sovereign debt globally now trades at negative yields.
This perverse environment has prompted David Rosenberg, chief economist and market strategist at money manager Gluskin Sheff + Associates in Toronto, to muse about the strange phenomenon of investors buying low- or zero-yielding bonds for capital gains and purchasing shares for income. With risk on government bonds increasing, equity analysts argue that investment in shares was preferable to bonds as they offered better protection from a rise in risk-free rates.
The lack of returns in government bonds has driven overvaluation in credit markets. Investors have taken on additional risk, moving into corporate bonds, driving rates lower, with the average falling under 2.9% in early 2015.
With rates on investment-grade corporate debt declining, investors have invested increasingly in higher yielding non-investment grade and emerging market debt, including by ever-more exotic issuers for Africa or Asia.
The risk-return relationship has deteriorated with investors no longer being compensated for the true default risk. Given the low absolute rates, investors are also increasingly exposed to higher interest rates. A 1% rate-rise will result in around a 7% loss in the value of U.S. corporate bonds, an increase of around 40% from the 5% percent loss five years ago.
Real estate prices have risen globally with investors purchasing rental income streams to diversify away from low income financial assets. Markets as disparate as the U.S., Canada, U.K., Germany, France, Scandinavia, Australia, New Zealand, China, India and many other emerging countries have become overheated.
Collectibles including fire art, vintage cars, wine, and the like also are showing the effects of excessive enthusiasm. Their prices reflect in part the desire by the world’s “smart money” to escape the manipulation of financial markets and the tremors that could be signaling a big quake to come.