How to judge if stocks are at the top
John Authers
There is reason to be worried but history shows, with central bank help, market can keep rising
Is this the top? And if it is, how can we tell? Nobody has ever quite trusted the US equity market throughout its prolonged six-year rally. This week, several different threads and snippets of information have combined to build the speculation that the market has at last topped out.
Last month saw the total volume of mergers and acquisitions in the US at last top its previous record, set in the summer of 2007 just before the credit crisis took the floor out from under the equity market. The news tended to be greeted with apprehension rather than joy.
That followed on the heels of April’s all-time record for companies’ purchases of their own stock, again beating a record set just before the credit crisis. When companies buy their own stock they imply that they have no decent growth opportunities to invest in instead — but they do act as valuable buyers to prop up the market.Then there were the dramatic events in the bond market, led in particular in a sharp upward move in German Bund yields. Ten-year Bund yields were barely above zero a few weeks ago — by Thursday lunchtime they had almost reached 1 per cent, after the sharpest two-day increase since October 1998.
This was not an auspicious parallel. That last sudden rise in Bund yields came as markets convulsed in the wake of the meltdown of Long-Term Capital Management. As yields rose, Alan Greenspan, then the chairman of the Federal Reserve, made one of the most alarming speeches of his tenure. “I’ve never seen anything like this,” he said. “What is occurring is a broad area of uncertainty or fear.” When humans are scared, he mused, “they disengage” which “of necessity means that prices fall”.
This week, Mario Draghi, president of the European Central Bank, was the central banker to rattle the markets. Many had hoped he would try to talk yields back down; instead he bluntly told investors they should be prepared for more bond market volatility, in a prophecy that immediately fulfilled itself.
In another worrying precedent, it was another sudden move higher in Treasury bond yields, in the summer of 2007, that lit the fuse of the credit crisis. And this makes logical sense. A sudden move in bond yields should alarm stock markets, as this raises the rates at which companies’ future earnings must be discounted and reduces their value.
Finally there was alarm that Wall Street’s most powerful bank, Goldman Sachs, appeared to have called the top. In a much-distributed document, Goldman’s analysts cited evidence from Professor Robert Shiller of Yale University, and others, to show that the stock market appeared badly overvalued, and attacked companies for engaging in buybacks.
There was little or no new information in this: more bearish commentators have been making such arguments for years. What was novel was that the mighty Goldman Sachs decided to publish it.
Maybe one final reason for worry is that the US stock market appears to have run out of puff. It is only barely below its top, but the S&P 500 is also, as of Thursday night, no higher than it was on December 29 last year. It has essentially flatlined all year. Forward momentum is now lacking.
So does this all point to a top? Not necessarily. First, timing market tops is prohibitively difficult. Markets can easily move from irrationality to even greater irrationality.
The revival of M&A looks more like a sign that the rally has reached its last stage, than that it has peaked
Second, valuation does not help. I agree with Professor Shiller and others that US stocks are overpriced, but they have already looked expensive for several years. Serious overvaluation suggests the fall when it happens could be great, but does not imply that the market is going to fall any minute now.
M&A certainly appears to be heading for a peak, but in real terms (adjusting for inflation), it is still short of the peaks of 2000 and 2007. The revival of M&A looks more like a sign that the rally has reached its last stage, than that it has peaked.
In any case, sentiment indicators are difficult to use, because this entire rally has been a strange one. There is nothing like the same euphoria surrounding mergers and acquisitions as could be felt at the last peaks in 2000 and 2007. Many distrust the rally, and most Americans have not been made wealthier by it. This makes stocks more vulnerable to a fall — but that has been true for some years.
Finally, and most importantly, note that the last two great jumps in bond yields may have portended trouble, but they were a long way from marking a top. In both 1998 and 2007, they prompted the Fed to cut rates, which breathed life into stocks. In 1998, Mr Greenspan took the dramatic step of cutting rates a week after his speech, and ignited the final insane stage of the dotcom rally. The top, it turned out, was 18 months away.
Even in 2007, the Fed’s response to the first onset of the credit crunch brought the stock market to a new high (and sparked a final mad rush into emerging market stocks). Many on Wall Street would deny that stocks were settling into a bear market right up until the bankruptcy of Lehman Brothers, more than a year later.
So, there is great reason to be worried by the way that sentiment is moving. High valuations leave the US stock market vulnerable to a big sell-off. But the history of the last two market booms and busts shows that cold economic logic can take a long time to make itself felt in the stock market, and that central bank intervention can delay the moment of reckoning. Sadly, it remains as true as ever that nothing matters more than the Fed’s next move on interest rates.
