American share valuations: overpriced?

http://www.economist.com/news/finance-and-economics/21721649-american-share-valuations-are-higher-now-eve-financial

  • May 2007: cyclically adjusted price-earnings ratio (CAPE), a measure that averages profits over ten years, was 27.6 for American equities. By March 2009 the CAPE had fallen by more than half.
    • Central banks then took action, slashing interest rates and buying assets via quantitative easing (QE)
  • Stockmarkets rapidly recovered and the S&P is now more than 50% higher than it was ten years ago
  • American stockmarket’s CAPE, at 29.2, is also higher than it was back then
  • A decade ago, the ten year Treasury-bond yield was around 4.8%; not it is 2.3% – the Fed may have started to raise rates but the return on cash is still pitiful in nominal terms and negative in real terms
  • There is no law that says the CAPE has to return to its long run average of 16.7; indeed, the ratio’s mean over the past 30 years has been 24.5.
  • When investors accept a high CAPE for shares, they are confident about the ability of companies to maintain, and increase, their profits
    • Election of Trump expects corporate tax breaks – which allows more profits to be passed on to shareholders
  • There has been a step change in level of American profits – partially insinuated by lower share of GDP for labour
  • Two forces behind higher profits:
    • enhanced monopoly powers for American companies;
    • low interest rates, which have allowed firms to operate with more debt
  • Both factors suggest something wrong:
    • if profit margins are high, then more capital ought to be ploughed into businesses until investment-led competition drives margins back down – which has not happened
    • low interest rates reflect, in part, the extraordinary measures taken by central banks to revive developed economies after the financial crisis
  • Threats to equity market:
    • sharp rise in interest rates
    • decline into recession
    • protectionist policies disrupt free flow of goods/services/people across borders
    • credit crisis – in China, where debt is growing rapidly
    • Flashpoints in the middle east or the Korean peninsula
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