The financial crisis of 2007-2009 was one of the worst recessionary periods in history. At its worst, it drove US equity markets down by almost 60% and resulted in the collapse of several once venerable financial institutions. In just a matter of weeks, liquidity was almost completely drained from the market and the surviving financial institutions parked every cent & penny they had left at the FED instead of lending to any other bank. A massive credit crunch followed, the housing market in the US in particular was severely wounded, and socials problem piled up.
It could have been much worse if central banks and in particular the Federal Reserve hadn’t been so bold and used their “magic tools” aka ZIRP and QE and in the process relieved most of the pain. The patient survived although recovery has been slow. Some four years after the crisis “ended” now is an opportune time to look back and ask some important questions. Is the worst now behind our backs? Has equity risk all been eliminated? And, are we really better off today than before the crisis?
The following chart shows the path of the S&P 500 since 1995. The picture is self-explanatory regarding the cyclical nature of the market. During the nineties, the S&P 500 rose extensively from under 600 in 1995 to over 1,500 in 2000. Tech companies were flying high with seemingly no limit to their valuations. That persisted until the turn of the millennia, when everybody realised that the madness was out of all proportion and with P/E’s ratio surpassing 100 in many cases, especially in Nasdaq stocks, there was only one way for prices to go. As companies can’t just magic revenues out of thin air (well, the honest ones!), the adjustment occurred in prices. By the spring of 2002 the S&P 500 had retreated to 800 – a fall of almost 50%.
With the tech bubble forgotten, markets once more began to rise on a wave of easy money and the S&P 500 reached almost 1,600 this time. The bomb that then exploded and that was ticking away was inside the housing market on this occassion and between 2007 and 2009 the market declined some 57%.
Now, here we go again. The prior crises seem once more to be forgotten… The S&P 500 has not only recovered every penny lost but also now risen above pre-crisis levels. It is currently trading near all-time highs and the danger signals mount by the day. Margin debt (credit given to buy stocks) has once more reaching an all-time high level near $384bn clearly showing how high investor confidence rose. People who lost half their savings during the 2007-2009 bear market are now entering the market once more in a (likely vain) attempt to recover their losses. But, as the market is supposedly a mirror of the economy (current and expected future), we should ask a simple question: has the economy actually recovered to such a degree to warrant the new valuation plane.
In a short and straight answer: No. Unemployment is still at 7.5% while it was below 5% pre-crisis, and GDP growth is still tepid. If everything was rosy in the garden, why would the FED insist in keeping its trillion dollar asset purchase program in place? What do they know that we don’t?
Economic performance is rachitic but yet investors are enthusiastic about the future once more. Let’s look at earning. P/E ratios are rising, as the denominator hasn’t been able to catch up with the numerator. In short, rices are rising faster than earnings. US companies have been struggling to significantly improve their bottom line because Europe isn’t recovering and the latest data still casts a shadow on expected growth out of Europe for next year. Since mid 2011, earnings haven’t been rising much but since bottoming in 2009, the S&P 500 has risen a whacking 150%.
The Shiller’s ratio or CAPE ratio if you prefer, is a good indicator of over and under valuation and is the only measure that really works over the longer term in telling you whether you should be in or out of the market. It importantly adjusts P/E ratios for inflation.
As you can see, it is on the rise, currently sitting at 24.66. Although the current value is nowhere near as high as the exuberance observed during the tech bubble, it is still above its average of 16.5 and now approaching pre-crisis levels. And yet, the QE programs and ZIRP policies tell us there is a crisis still… Who is right and who is wrong?
The S&P 500 and other main US indices point to an economic nirvana, one where there is no “broken” Europe, where the US’s unfunded liabilities running to tens of trillions of dollars don’t exist, where the QE inflation in the equity market (at least 20% in our opinion) is to be disregarded, where “real” inflation is not really squeezing consumers, where China is not slowing and resuming a lower growth trajectory going forward and where the $4tn of injected capital into the US banking system is not either (a) covering up bad debts or (b) will ultimately escape and ignite the long overdue inflation.
We don’t share the enthusiasm that it seems mainstream investors have at this point. We believe there is a very broken link between real economic conditions and financial markets, precisely due to FED intervention. At least 200-300 points in the index are made out of thin air and, in our opinion, will disappear at the first signs of FED tapering. Something we expect to happen at the end of this year/beginning of next and that we actually touched upon way ahead of the pack at the beginning of the year (see Guide below to see what we said then)
Our Titan Global Macro Fund is currently invested materially in index short positions in anticipation of a market correction this quarter. For more details click here (http://www.titanip.co.uk/wp-content/uploads/2013/07/Global-Macro-PDF.pdf) for our latest PDF or the banner below for more details on our funds.
R Jennings, CFA. Fund Manager Titan Investment Partners