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There is no stock market bubble

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Are stock markets, especially the US market, in a bubble that is sure to pop? The answer depends on prospects for corporate earnings and interest rates. Provided the former are strong and the latter ultra-low, stock prices look reasonable.

The best-known measure of market value — the “cyclically adjusted price/earnings ratio” of Yale’s Nobel laureate, Robert Shiller — is indeed flashing red. One can invert this metric, to show the yield: on the S&P Composite index, this is just 3 per cent today. The only years since 1880 it has been even lower were 1929 and 1999-2000. We all know what happened then. (See charts.)

Wolf charts: The ups and downs of the cyclically adjusted earnings yield on US stocks

Another price is also exceptionally low by past levels: interest rates. The short-term nominal interest rate is near zero in the US and other high-income economies. US short-term real interest rates are about minus 1 per cent. Real yields on US 10-year Treasury-inflation-protected securities are minus 1 per cent. In the UK, yields on similar securities are about minus 3 per cent.

Desired returns on equities ought to be related to the returns on such supposedly safe assets. This relationship is known as “the equity risk premium”, which is the excess return sought on equities over the expected returns on government debt. This premium cannot be measured directly, since it only exists in investors’ minds. But it can be inferred from past experience, as explained in a 2015 paper by Fernando Duarte and Carlo Rosa for the New York Federal Reserve. More recently, in the Credit Suisse Global Investment Returns Yearbook 2020, Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School estimated the excess return on world stocks over bonds at 3.2 percentage points between 1900 and 2020. For the UK, the excess is estimated at 3.6 percentage points; for the US, at 4.4 percentage points.

Wolf charts: Equities have delivered higher returns than bills or bonds in the long run

Are these excess returns in line with what people initially expected? We do not know. But they are a starting point. The premium demanded now might be lower than that sought for much of the past 120 years. Corporate accounting has improved greatly. So, too, has macroeconomic stability — at least by the wretched standards of the first half of the 20th century. Moreover, the ability to hold diversified portfolios is far greater now. Such changes suggest the risk premium, often believed to be excessive, should have fallen.

The Credit Suisse study estimates aggregate real returns on stocks and bonds in 23 markets weighted by market capitalisation at the start of each year. It shows, interestingly, that the excess return of equities since 1970 have been very low and since 1990 negative. But this is because of very high real returns on bonds, as inflation and real interest rates collapsed. Looking ahead, it estimates the prospective excess return of equities at 3.3 percentage points. This is the same as the long-run historical average.

Wolf charts: Low prospective returns on bonds support equities

Estimates of Shiller’s metric do not exist for such lengthy periods for non-US stock markets. But estimates can be made since the early 2000s. The cyclically adjusted earnings yield is currently 7.6 per cent on the FTSE 100, 5.4 per cent on the DAX 30 and 4 per cent on the Nikkei 225. At current real interest rates on long-term bonds, the implied equity return premium is thus over 10 percentage points in the UK, over 7 percentage points in Germany and 4 percentage points in Japan and the US. The UK market looks extremely cheap today, perhaps because of the Brexit lunacy. Japan and the US look well valued, but not, by historical standards, overvalued.

Further support for the rationality of the US market today is that 55 per cent of the increase in the S&P 500’s market value over the past 12 months is due to gains in the information and technology sector. This makes sense, given US dominance in these areas and the technological shift of 2020. We should also note that real interest rates below zero make future profits more valuable than profits today, in terms of present value. Looking through the short-term impact of Covid-19 makes sense.

Wolf charts: Falling real bond yield supports US stock prices

Given the interest rates, then, stock markets are not overvalued. The big questions are whether real interest rates will jump, and how soon.

Many believe that ultra-low real rates are the product of loose monetary policies over decades. Yet, if that were right, we would expect to see high inflation by now.

A better hypothesis is that there have been big structural shifts in global savings and investment. Indeed, Lukasz Rachel of the Bank of England and Lawrence Summers of Harvard argued in Brookings Papers 2019 that real economic forces have lowered the private sector’s neutral real interest rate by 7 percentage points since the 1970s.

Wolf charts: UK stock prices look cheap given high earnings and low bond yields

Will these structural, decades-long trends towards ultra-low real interest rates reverse? The answer has to be that real interest rates are more likely to rise than fall still further. If so, long-term bonds will be a terrible investment. But it also depends on why real interest rates rise. If they were to do so as a product of higher investment and faster growth, strong corporate earnings might offset the impact of the higher real interest rates on stock prices. If, however, savings rates were to fall, perhaps because of ageing, there would be no such offset, and stock prices might become significantly overvalued.

Some major stock markets, notably the UK’s, do look cheap today. Even US stock prices look reasonable, valued against the returns on safer assets. So will the forces that have made real interest rates negative dissipate and, if so, how soon? These are the big questions. The answers will shape the future.

Wolf charts: The technology sector dominates the rise of the US stock market

martin.wolf@ft.com

Follow Martin Wolf with myFT and on Twitter





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Earnings beats: lukewarm reaction shows prices are stretched

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Investors are picking over first-quarter results for signs of economic recovery and proof that record market highs can continue. Stock markets have only been this richly valued twice before — in 1929 and 2000. Bulls hope strong corporate earnings and rising inflation can pull prices higher still. But pricing for perfection means even good results can be met with indifference.

L’Oreal illustrated this trend on Friday. The French cosmetics group stated that sales in the first quarter of the year rose 10.2 per cent. This was a better performance than expected. Yet the announcement sent shares down by around 2 per cent. Weak cosmetics sales were seen as a veiled warning that consumers emerging from lockdowns might not spend as freely as hoped.

Online white goods retailer AO World, a big winner from pandemic home upgrades, also offered a positive update this week. In the quarter that marked the end of its financial year, sales were £30m ahead of forecasts. But even upbeat commentary from boss John Roberts could not stop shares slipping 3 per cent.

Banks are not immune. Their stocks have outperformed the market by 7 per cent in Europe and 12 per cent in the US this year. But stellar Wall Street results were not enough to satisfy investors this week.

JPMorgan Chase, the biggest US bank, smashed expectations for the first quarter. Even adjusting for the release of large loan loss reserves, earnings per share beat expectations by 12 per cent because of higher investment banking revenues. Bank of America earnings also rose thanks to the release of loan loss reserves. Yet shares in both banks ended the week down. Goldman Sachs had to pull out its best quarterly performance since 2006 to hold investor interest.

On multiple metrics, stock valuations look steep. On price to book, banks are now back to the pre-crisis levels recorded at the start of 2020. Living up to the expectation implicit in such valuations is becoming increasingly hard.

Lex recommends the FT’s Due Diligence newsletter, a curated briefing on the world of mergers and acquisitions. Click here to sign up.



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Barclays criticised for underwriting US private prison deal

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Barclays has attracted criticism for underwriting a bond offering by the US company CoreCivic to fund the building of two new private prisons, in a new dispute over Wall Street’s relationship with the controversial sector.

The UK-based bank said two years ago that it would stop financing private prison companies, but the commitment did not extend to helping them obtain financing from public and private markets.

About 30 activists and investors, among them managers at AllianceBernstein and Pax World Funds, have signed a letter opposing the $840m fundraising for two new prisons in Alabama, which was due to be priced on Thursday.

The signatories said the bond sale brings financial and reputational risk to those involved and urged “banks and investors to refuse to purchase securities . . . whose purpose is to perpetuate mass incarceration”.

Activists and investors who pay attention to environmental, social and governance issues have sought to cut off companies that profit from a US criminal justice system that disproportionately incarcerates people of colour. As well as raising ethical issues, many also say such financing may be a bad investment because legislators are increasingly calling for an end to the use of private players in the prison system.

While Barclays is not lending to CoreCivic, activists and investors attacked its decision to underwrite the deal, which is split between private placements and public issuance of taxable municipal bonds. The arrangement is “in direct conflict with statements made two years ago” when the bank announced it would no longer finance private prison operators, according to the letter.

Barclays said its commitment to not finance private prisons “remains in place”, adding it had worked alongside representatives from the state of Alabama to finance prisons “that will be leased and operated by the Alabama Department of Corrections for the entire term of the financing”.

CoreCivic said the Alabama facilities will be “managed and operated by the state — not CoreCivic. These are not private prisons. Frankly, we believe it is reckless and irresponsible that activists who claim to represent the interests of incarcerated people are in effect advocating for outdated facilities, less rehabilitation space, and potentially dangerous conditions for correctional staff and inmates alike.”

Barclays’ 2019 commitment to limit its work with private prison companies came as other banks, including Wells Fargo, JPMorgan Chase and Bank of America, also said they would stop financing the sector.

Critics said they were not sure why Barclays is differentiating between lending and underwriting.

“You’ve already taken the stance, the right stance, that private prisons and profiting from a legacy of slavery is bad,” said Renee Morgan, a social justice strategist with asset manager Adasina Social Capital, one of the signatories of the letter. “But then you’re finding this odd loophole in which to give a platform to a company to continue to do business.”



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Hedge funds post best start to year since before financial crisis

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Hedge funds have navigated the GameStop short squeeze and the collapse of family office Archegos Capital to post their best first quarter of performance since before the global financial crisis.

Funds generated returns of just under 1 per cent last month to take gains in the first three months of the year to 4.8 per cent, the best first quarter since 2006, according to data group Eurekahedge. Recent data from HFR, meanwhile, show funds made 6.1 per cent in the first three months of the year, the strongest first-quarter gain since 2000.

Hedge fund managers, who often bet on rising and falling prices of individual securities rather than following broader indices, have profited this year from a rebound in the cheap, beaten-down so-called “value” stocks and areas of the credit market that many of them favour. Some have also been able to profit from bouts of volatility, such as the surge in GameStop shares, which turbocharged some of their holdings and provided opportunities to bet against overpriced stocks.

“We’re going into a market environment that is going to be more fertile for most active trading strategies, whereas for most of the past decade buying and holding the index was the best thing to do,” said Aaron Smith, founder of hedge fund Pecora Capital, whose Liquid Equity Alpha strategy has gained around 10.8 per cent this year.

The gains are a marked contrast to the first three months of 2020, when funds slumped by around 11.6 per cent as the onset of the pandemic sent equity and other risky markets tumbling. However, funds later recovered strongly to post their best year of returns since 2009.

This year, managers have been helped by a tailwind in stocks and, despite high-profile losses at Melvin Capital and family office Archegos Capital, have largely survived short bursts of market volatility.

It’s a “good market for active management”, said Pictet Wealth Management chief investment officer César Perez Ruiz, pointing to a fall in correlations between stocks. When stocks move in tandem, it makes it more difficult for money managers to pick winners and losers.

Among some of the biggest winners is technology specialist Lee Ainslie’s Maverick Capital, which late last year switched into value stocks. Maverick has also profited from a longstanding holding in SoftBank-backed ecommerce firm Coupang, which floated last month, and a timely position in GameStop. It has gained around 36 per cent. New York-based Senvest, which began buying GameStop shares in September, has gained 67 per cent.

Also profiting is Crispin Odey’s Odey European fund, which rose nearly 60 per cent, having lost around 30 per cent last year, according to numbers sent to investors.

Odey’s James Hanbury has gained 7.3 per cent in his LF Brook Absolute Return fund, helped by positions in stocks such as pub group JD Wetherspoon and Wagamama owner The Restaurant Group. Such stocks have been helped by the UK’s progress on the rollout of the coronavirus vaccine, which has raised hopes of an economic rebound.

“We continue to believe that growth and inflation will come through higher than expectations,” wrote Hanbury, whose fund is betting on value and cyclical stocks, in a letter to investors seen by the Financial Times.

Additional reporting by Katie Martin

laurence.fletcher@ft.com



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