David Rosenberg is chief economist with Gluskin Sheff + Associates Inc. and author of the daily economic newsletter Breakfast with Dave
Are U.S. equities overextended?
Well, the first issue that must be addressed is: What exactly constitutes an overextended market to begin with? There are so many ingredients to take into account.
Here they are, all five of them – you be the judge:
1. Valuation (overly high pricing relative to underlying fundamentals);
2. Sentiment (too much optimism);
3. Ownership (concentration of assets);
4. Leverage (overreliance on margin debt);
5. An entrenched belief system (that prices can't go down).
So here we go:
1. Valuation
The U.S. stock market, in aggregate, and this includes all companies from large to mid-sized to small caps, and from publicly listed to private equity, now comprises 207 per cent of gross domestic product.
This is unprecedented, not to mention more than double the long-run average of 102 per cent.
Some may say that such a valuation is warranted due to low interest rates, but actually, the historical norm is 138 per cent when we consider only those periods when bond yields were about where they are today.
Comparing this value of U.S. corporate equity to the Bureau of Economic Analysis' estimate of aggregate corporate profits shows a multiple of 18.2 times, which is almost double the norm of 10.9 times.
Again, using "low interest rates" as your bullish argument doesn't hold up because in the past when yields were at or near current levels, this multiple averaged out to be 11.8 times.
2. Sentiment
The Investors Intelligence poll is back to three-week highs (and still not far off 30-year peaks) of 56.3-per-cent bullish and the bear camp is down to 17.5 per cent. When we have more than three bulls for every bear, that is usually grounds for believing that we have a fully priced market on our hands – and then some.
3. Ownership
The total equity share in U.S. household assets (as per the Fed flow-of-funds data) has risen this cycle to 21 per cent. Remember, this includes all assets, including property.
The historical norm is closer to 15 per cent and only twice in the past was the concentration this high (or higher) and that was in 2000 and before that the late 1960s.
If you recall, both these periods represented the tail end of secular bull markets that precious few saw ending.
4. Leverage
Margin debt has expanded sharply in recent months and at 2.6 per cent of the New York Stock Exchange market capitalization, it has already broken above the 2007 peak (which everyone now acknowledges was a bubble, although back then, that was a very controversial comment), and is now the highest level since investors loaded up on debt in their margin accounts to play the tech mania.
All anyone needs to know is that margin debt balances have ballooned at over a 20-per-cent rate on a year-over-year basis.
5. An entrenched belief system
Every bull-market mania has its own label, and this tends to happen late in the cycle. Like the "Roaring Twenties," which took hold late in the Gatsby-esque decade. Or the "Nifty Fifty" label in the late 1960s. Or the "Dot-com" craze, which took on its own nickname in the late 1990s.
The acronym era came to define the peak of the last cycle, from HELOC (home equity line of credit) to MEW (mortgage equity withdrawal) but became known as the CDO (collateralized debt obligation) rally.
And this one has been called the "Trump Rally" (even though, even after seeing the S&P 500 triple from the lows of March, 2009, to November, 2016, nobody ever called it the "Obama Rally.")
So here we have economic expectations, until recently, soaring to levels not seen since the early days of the George W. Bush presidency.
The term "Trumponomics" now has 367,000 Google search results while the "Trump rally" has a whopping 74 million results. If these numbers don't classify as a phenom, what ever would?
The belief that we are embarking on a new era of lower tax rates, massive infrastructure spending and deregulation has indeed become very well entrenched.
So much so, in fact, that households' expected mean probability of higher stock prices in the next year, as per the University of Michigan Surveys of Consumers report, has jumped 7 percentage points since the November election to 61.4 per cent.
Households are also shown to be bullish on equities in the Conference Board Consumer Confidence report – 47.4 per cent see higher stock prices, already taking out the former cycle high of 40.2 per cent in May, 2007, and the highest it has been since the Nasdaq and tech mania saw its last best days in early 2000.
Which reminds me of investment legend Bob Farrell's "10 Market Rules to Remember": "There are no new eras – excesses are never permanent."
Anyway, I hope I helped guide you to the appropriate answer to the initial question. It is a good thing that we are positioned for an interim pullback, and stand ready to put cash to work once these five metrics revert to more normal levels.
David Rosenberg is chief economist with Gluskin Sheff + Associates Inc. and author of the daily economic newsletter Breakfast with Dave.
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