Water cooler reflections : December 2016

We celebrate this week the 20^th anniversary of the “irrational exuberance” speech by the former Federal Reserve President Alan Greenspan in which he questioned if the definition of price stability should include financial assets. (https://www.federalreserve.gov/boarddocs/speeches/1996/19961205.htm).

 The key passage in this speech was:

“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”
Alan Greenspan, 5 December 1996.

A lot has happened since then, to say the least. Price stability and financial assets stability have been deeply stress-tested over the last 20 years…

But back to Greenspan. In December 1996, the S&P 500 was trading at a very high multiple (see the chart, below), at which point, Greenspan started to feel uncomfortable, leading to his officially-voiced concerns about “irrational exuberance”.

We open the debate again in this letter, not because we feel uncomfortable with current equity valuations, but because we suspect that the conditions are right for a super-cycle for US equities.

In our opinion, the question of equity valuations, which is implicit in the question raised by Mr Greenspan, is today THE main theme for investors. The current forward P/E ratio of the S&P 500 is testing its highs and that cannot be ignored. Will it stop there? Why should it stop?

If we use models to assess the fair P/E ratio of the US equity market, we get a wide range, which doesn’t allow us to draw any strong conclusions. Using key macroeconomic variables, such as inflation vs growth, we can easily justify current valuations. However, looking back to the 1996-2002 cycle, we see that, from 1998, the equity market started to overshoot significantly and it is not until the profit recession of 2002 that the index moves back to “justifiable territory”.

Why did we witness such a long and strong overshoot, and what might be different (or similar) this time?

On an ex-post basis, we can make some assumptions about the reasons for this exuberance. First, mass computer use and the emergence of the internet led to the IT revolution -  a disruptive phenomenon. Second, capitalism hugely expanded its footprint in the 1990s, especially in Europe. This was accompanied by a number of business-friendly events, such as stronger globalization, lower interest rates and the opening-up of some public sector assets to competition.

In our opinion, this combination - Phase I of the IT revolution and the “release of animal economic forces” – could explain the mania for large-cap growth stocks at the end of the last century.

Today, a pragmatic interpretation of the current high p/e ratio for US equities could be that the context is, once again, very supportive. This is our belief.

Twenty years on, there is no mania, in our opinion, just the reality that some segments of the stock market never stop growing. We mentioned it in a previous “Water cooler reflections” note, when we gave our thoughts on the two-speed economy (old vs new). The theme returns here: there are a great number of growth stocks and, in the US, they now have a significant weighting in the benchmark index (the S&P 500).

So the primary driver of financial markets in 2017 will not be the Fed or the French/German elections, but the unfolding of the IT revolution Phase II. There is significant “upside risk” for US equity indices, similar to what happened in 1996-1998, if investors shift from their current over-rational stance, to a stance based on extrapolative expectations.

The current 12-month forward p/e of the Nasdaq 100 is 18. Why so low if these companies are about to change the entire way that economic agents interact?

In addition, our thesis does not focus solely on the IT revolution, but also the impact, at many levels, of IT technologies on the wider economy. Perhaps history will record that the 2009 crisis was actually a crisis of the old economy, and was then followed by an economic revolution, led by a new economy which had emerged 20 years previously.

Overall,  the apparent risks (interest rates, the business cycle, geopolitical risk) will in 2017 remain a distraction only for commentators, while the genuine opportunity for investors will lie in the price of what works well in this world. Can the S&P 500 trade at 20 times forward earnings? That’s the question.

Commentators are prisoners of their emotions and unusual risks affect their perception. Assets are less biased. That was the lesson of 2016. The S&P 500 accelerated in 1997-1998 even though the ISM Manufacturing Index was low and falling. This acceleration was not stopped by two emerging market crises – Russia and Asia – either.

Think about it. The human perception of risk is not that of financial markets.