If you buy stocks at nosebleed valuations people consider you a fool. Who cares, says the fool, if there is a greater fool that he can sell to.
As the Dow Jones and the S&P 500 reach for new all-time highs it becomes moot to talk about valuations. Even taking into account the optimistic analyst estimates for the next 12 months, the S&P is trading at 15.5 times earnings, according to Factset.
Longer term valuation indicators such as the business cycle and inflation-adjusted Shiller PE, Tobin’s Q, or total market cap to GDP ratio all indicate severe overvaluation.
“The delusion is that this Fed-induced reach for yield is enough to make equities a sound investment at any price,” wrote fund manager John Hussman in his recent market report. Based on proprietary valuation methods, Hussman managed to avoid the tech crash in 2000 and the housing bubble in 2007. In turn, his methodology signaled a buying opportunity in 2003 and late 2008.
He thinks the S&P will return around 2 percent annually over the next 10 years because valuations are so high.
Who’s Buying
So who’s the fool left buying?
It turns out, there are several. The Federal Reserve is not buying directly, but at least provides enough juice for speculators with its ongoing quantitative easing (QE) program. Retail investors have pumped $218 billion into global equity mutual funds since the beginning of 2013, according to ICI Global.
Also, there is the phenomenon of corporations borrowing money to buy back their own stock, completely disregarding price and valuation.
Now, we find out there is another big buyer with deep pockets out there that not many people have heard about. Central banks and public sector investment funds have splurged $1 trillion on public equities worldwide in the last few years, according to a report by think tank Official Monetary Financial Institutions Forum.
“One of the reasons for the move into equities reflects central banks’ efforts to compensate for lost revenue on their reserves, caused by sharp falls in interest rates,” states the report. Here we have Hussman’s reach for yield again.
The report cites $29.1 trillion worth of assets held by 157 central banks, 156 pension funds, and 87 sovereign investment funds worldwide. Some of the bigger players are China’s State Administration of Foreign Exchange and Japan’s Government Pension Investment Fund as well as the California Public Employees Retirement System.
These institutions are desperate, as central banks alone have lost $200 billion to $250 billion in forgone interest income over the last years. So they go to the only place left where prices aren’t cheap but returns are guaranteed. After all, the Fed has investors’ backs, right?
Circular Loop
No, said Hussman: “It’s entirely that reach for yield that investors must rely on continuing indefinitely, because there’s no mechanistic cause–effect relationship between the Fed balance sheet and stock prices, bank lending, or economic activity.”
Since both corporations and public institutions have pretty deep pockets, this game could go on for a while. If history is any guide, however, it won’t last forever.
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