Markets really have been on a roller coaster ride since the Brexit vote. Major equity indices have enjoyed a remarkable rally the last few days predicated we believe on hopes for a further round of monetary easing and perhaps some fiscal stimulus as well. Bond prices have risen as the economic outlook dims and the hunt for yield continues. Precious metals have also performed strongly as some investors hunt out protection from increasingly extreme central bank policies. Can all of these assets continue to rise together?

The actions of central banks are increasingly distorting financial markets. Negative interest rates and QE in Europe and Japan have resulted in approximately US$12 trillion of bonds now trading with a negative yield. This distortion has forced investors to hunt for yield which has driven yields down in all Sovereign bonds as well as corporate bonds regardless of credit quality. Unless the world economy is heading into a Japan like lost decade (which is certainly a possible outcome in our opinion), Government bonds represent utterly disastrous value for investors.

Chart 1 – Selected 10 year bond yields since 2005

The increasingly extreme policies of central banks seem to be worrying some investors. Nobody knows the true long term consequences of such policies and there are some who believe that the current negative rates and QE are actually doing more harm than good. However, at every negative turn, central bankers simply continue to do more of whatever it takes, regardless of the long term risks. Having been in a bear market for more than four years, it would appear that the price of Gold has turned a corner this year and embarked on a new long term bull market.

Chart 2 – The price of Gold since 2005


So what of equities? It appears that traders are excited enough about more Central Bank stimulus to drive prices higher in the short term. However, valuations in the US are extremely stretched, negative rates and QE in Japan and Europe have hardly helped in recent months and corporate cash flows will surely get hit hard in the event of a global recession.

With the risks more obvious in UK/Europe at the moment, investors have been rerating US equities relative to the rest of the World. How expensive are US equities? On some measures, they are in bubble territory (not quite as expensive as at the height of the dotcom boom) and just as expensive as in 2007. What is remarkable is looking at the median stock valuation as opposed to the average. The next chart shows the Median price to revenue of S&P 500 components (courtesy of John Hussman), and as can be seen the median stock is now the most expensive ever in history.

Chart 3 – Median Price / Revenue Ratio of S&P500

John Hussman really does produce some powerful analysis for long term investors. Recently, he took Warren Buffets previously favourite quick stock market measure of market capitalisation to GDP, and changed it to Corporate Gross Value Added to GDP. This is shown in the chart below (in blue and inverted) alongside the subsequent actual 12 year annualised nominal returns (in red). The correlation between this measure of market value and subsequent 12 year returns is 93%; a truly remarkable statistic. Investors need to accept that the total nominal return for buy and hold investors (12 years on this basis) is going to be about 2% before fees and slippage. The potential for a very damaging bear market during that 12 year period is very high.

Chart 4 – Corporate Gross Value-Added to GDP

So, with US stocks so expensive, where should investors look? Our simple view is a US bear market would impact global markets to varying degrees. There is little doubt that Emerging Markets offer somewhat better value than the US, however, these economies remain very vulnerable in the event of a global shock. Europe also looks better value than the US, but the structural headwinds and rising political risks make it hard to be too optimistic in the short term. Perhaps the Bank of Japan can kick-start their equity market with more stimulus later this month? We’ll see.

We also worry that investors have become far too complacent about lower quality corporate bonds. In the US, the Junk Bond ETF yields about 5.8% and the expected default rate this year is 6%. We do not expect robust returns from this asset class either.

It appears to us that central banks have distorted financial markets to such a degree that there really is very little fundamental value in buying many mainstream assets at this juncture. And yet, we have markets rallying strongly this week on hopes for more central bank stimulus – policies that have failed to generate robust economic growth and only seems to be increasing inequality which seems to be at the heart of the disgruntled electorate in many developed countries.

The main question has to be whether markets have started a multi week rally similar to that seen between February and April when central banks unleashed another round of stimulus. Or, is the current four day rally simply a quarter end squeeze that will soon peter out? We are very much leaning towards the latter although it seems that anything is possible in todays distorted market place and so we have to be careful about being too bearish at this stage.
Stewart Richardson
Chief Investment Officer