Tuesday, 5 March 2013

Dow Hits New All-Time High - Then What?

The Dow Jones 30 Index, having been toying with it for the last few weeks, has just exceeded its all-time intra-day high.  The question is then what?

As I pointed out recently - The Bust Without A Boom - all sorts of asset markets have been bubbled up once again in the last four years, as a result of massive money printing, but the underlying fundamentals have not improved.  In many ways, the situation is worse than it was in 2008, for exactly that reason.  In the West, the economy is really not that great, and unlike 2008, there are obvious bubbles in pretty much every asset class.  When one of those bubbles bursts its likely to explode all the others dramatically.

US markets are valued at around 13-14 times last year's earnings, and about 15-16 times next year earnings.   This is not that overstretched compared to the over valuation there has been during previous stock market bubbles, but then this is a market that only four year's ago suffered a serious setback.  It is in economic conditions being supported by unprecedented levels of money printing.  It assumes that the projections of next year earnings are accurate, which they may not be.  In fact, they could prove to be extremely optimistic.  But, even set that aside, at these levels the market can hardly be described as cheap either.

At depressed levels, prices are usually around 8 times earnings, so at current levels, prices are approximately double that.  My own valuation model, sees prices being cheap at 8 times, fair value at 10, and expensive at 12, as well as requiring that the company should be able to cover its dividend twice over, have a dividend yield of at least 6%, and have gearing of less than 50%.  Given that many of the firms that have lower p/e ratios may be ones that have financed themselves a lot using cheap borrowing, I wouldn't see these markets as in any sense a buy.  On the contrary, I suspect that this current intra day high, may be the point where a lot of people decide to take profits.

The only thing complicating things is the fact that the massive money printing has caused a problem of where the money goes.  Bonds are clearly in a bubble, that must burst.  At these levels there would normally be a rotation out of Bonds into Equities.  But, Equities are not cheap, and current share prices seem to be based on institutional buying rather than that from individuals.  Individuals seem still scared out of the market, having had their fingers burnt in 2000, and 2008.  Its possible the real market collapse could come, when individual investors, come back in, too late, as they normally do, having seen the market reach new highs.

Sometimes, you have to use your gut alongside analysis of the data in these things, because, as Keynes realised markets are driven by psychology not rationality.  The same thing is true about UK markets, like housing.  The inane Daily Express had another headline the other day, proclaiming that house prices were rising still.  Yet, anyone with eyes, certainly outside London, can see that is far from the case.  The data itself, which the Express was referring to showed that in the North-West prices had fallen by more than 7%.  That is despite all of the pump priming by the Government and Bank of England via, Funding For Lending, which has failed to increase lending to businesses, and which has simply subsidised banks lending to those mortgage borrowers they would have lent to anyway.  It is also despite, large scale forbearance by banks on mortgage arrears, and mortgage repayments at the cheapest they have been for 15 years.  Yet, house prices continue to be unaffordable to the vast majority of first time buyers, and at levels that prevent people moving to a better house.

The real situation is indicated by the fact that the Bank of England is now even proposing introducing negative interest rates i.e. charging banks for the privilege of depositing their money at the Central Bank.  In fact, in the modern world, that is likely to simply lead banks to move their deposits from the Bank of England offshore, for example, to the ECB, or some other Central Bank that would pay them a higher rate, to buy higher yielding Corporate Bonds, or even to buy other assets such as Gold.  What its not likely to do is to get those banks to lend to people who really don't want to borrow, or to people who really can't afford to borrow, and who probably wouldn't pay it back, because they are likely to go bust!

An example, of using your gut was today as I was out for a walk.  I've mentioned in the past that I'm renting a house in a very nice village, where the majority of inhabitants are quite affluent.  Its a village which has been much sought after, because the dozen or so properties there rarely come up for sale.  Since I've been here, 7 places have come up for sale, 3 were eventually sold.  One of those was sold at a 10% discount in 2010, another was sold at a 25% discount last year, and another was sold with a 15% discount last year.  Of the others, one was bought in a private sale in 2010, and has remained empty ever since.  Two of the others have now been up for sale for a year.  One has been reduced by 10%,  the other by nearly 20%.  Both have changed their agents, one of them twice.  The final property a derelict cottage on about 6 acres of land was put up for sale by sealed bid last year with no offers being received.

But, when I was out I saw yet another for sale sign had been erected for land for sale, at the final property.  It seems the buyers who had bought the house and land (4 acres) had done so speculatively, in the expectation that house prices would rise, and thereby net them a decent Capital Gain.  Why wouldn't they expect that given the repeated stories in the Express and other parts of the media that house prices are rising???  But, it seems the nerve has cracked.

Sooner or later, that is the psychology that overwhelms markets.  Sooner or later appearance and reality are realigned.

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