Investors around the world are in a kind of limbo at present, because although they know stock markets and other asset classes are over-valued, nobody seems to know what to do about it.
Financial commentators have been worrying this week about a valuation method used by US economist Robert Shiller that compares the price of shares with the dividends paid on those shares.
The ‘price-to-earnings’ ratio is one of the most common metrics used to analyse shares, but Mr Shiller’s team at Yale University takes the basic numbers and adjusts them to take account of inflation and movements in the business cycle.
The result is the ‘cyclically adjusted price-earnings’ or CAPE ratio, shown in the chart below.
The index has averaged 17.4 since the end of World War I, but currently sits a touch under 31 – which is just a whisker under the figure it hit on the eve of the 1929 stock market crash that kicked off the Great Depression.
There is a major difference, however, between those two moments in history.
The first was a true case of the ‘irrational exuberence’ that has characterised all great asset bubbles since the infamous ‘Dutch tulip bubble‘ of the 1630s.
But today’s ‘bubble’ has been consciously inflated by central banks, which for eight years have been flooding markets with money supply via low interest rates and the bond-buying programs known as ‘quantitative easing’.
So, investors who would normally be getting nervous at a price-to-earnings ratio of 31 are not terribly worried at all. By not dumping their stocks, they are demonstrating a degree of confidence that the central bankers know what they’re doing.
But do they? This really has never been tried before. As noted on Wednesday, the US Federal Reserve is sitting on a $US4.5 trillion ($A5.75 trillion) pile of bonds bought as part of quantitative easing.
If it sells those down gradually, as it plans, then perhaps the CAPE ratios above will slowly come down too – that is, they all hope a 1929-style event will be avoided.
But nobody knows if that is possible. The Fed pretty much holds a media conference if it thinks it’s going to sneeze these days, so as not to spook the market.
Traders basically know months in advance when the Fed is going to raise rates, and how much of that stockpile of bonds it intends to sell back into the open market.
So, perhaps investors are right to cross their fingers and hold onto their ‘over-valued’ stocks.
One more argument against panicking is that the CAPE index uses a 10-year average of a company’s earnings to calculate its price-to-earnings ratio – and a good chunk of the past 10 years, during the worst part of the global financial crisis, saw earnings tank.
That means that when those bleak years fall out of the 10-year calculation in a few years time, Mr Shiller’s scary stats should look a lot better.
And let’s not forget that during the irrational period of exuberance known as the dot-com bubble, things got far crazier – the CAPE index was brushing 44 before the market imploded in early 2000.
Overall then, it’s right to be nervous about stock markets climbing to such wobbly heights. However, what each individual should do about it is another matter.
In general, younger investors can afford to risk being swept up in a market sell-off because they’ve got years for that slump to be averaged out by more bullish periods.
Conversely, investors nearing retirement usually want a lower risk profile, and so would probably do well to speak to a financial adviser about whether current markets have pushed them too far out of their comfort zone.
The alternative, which was popular before the 1929 crash, is to spend nights in swinging jazz bars, drink plenty of cocktails, and live it up while you can.