Plenty of signs of froth in equities
November 26, 2013 Leave a comment
Last updated: November 25, 2013 9:14 pm
Plenty of signs of froth in equities
By James Mackintosh
Prepare for slower but still acceptable share gains
Equity markets move in cycles, from despair through disbelief to euphoria and back. One of the skills of the investor is to judge where in the cycle they are, and invest accordingly. At the moment, there are plenty of signs of froth. Perhaps the market is reaching the euphoria stage? Peter Oppenheimer, European equity strategist at Goldman Sachs, thinks not. He puts the region in the third phase of a four-stage cycle starting with despair, hope, then growth and finally optimism.Since 1973, the typical cycle has seen hope last for 10 months, driven by increased valuations in the expectation of profits to come. The growth phase then delivered profits over three years, while the valuation of those profits – the price-to-earnings ratio – came back down. Share prices rose, but more slowly. Once optimism kicked in, valuations drove more rapid price rises again, until it became clear that sluggish profits presaged a fall, when despair started over.
There are other ways to classify the cycle, but as ever the problem is applying the model. Clearly despair and hope followed each other quickly in 2008 and 2009. Mr Oppenheimer puts 2010-11 back in despair thanks to fears of euro break-up, which would suggest the gain of a fifth in eurozone shares this year was a new hope cycle. On this basis, prepare for slower but still acceptable share gains.
Apply the pattern to the US and it looks very different. The growth phase involved a hefty correction because of the euro crisis, but the basic model held. In the last optimistic phase, Goldman says shares typically return 27 per cent in 14 months, driven by soaring valuations. In the past 12 months the S&P 500 has risen 30 per cent, with a 23 per cent rise in the forward PE ratio.
Bears can add this to their evidence of excessive optimism. Bulls must hope global economic growth will push up sales (US profit margins surely can rise no further), confirming a long “growth” phase. As always, no two cycles are enough alike to make it easy.
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