Now that it's been a good decade since the beginning of the last financial crisis, it's about time to start demanding information about the next one. In a Monday note to clients on the subject, Deutsche Bank's Jim Reid shared some ideas you've probably heard before – QE reversal, populist electoral victories, China, etc – but he's also got something new to show you. For one thing, this chart:
Everyone knows assets are on the pricey side these days, but few charts convey the point as compellingly as this one. Writes Reid: “We’re in a period of very elevated global asset prices – possibly the most elevated in aggregate through history.” That's mostly the fault of bonds, but equities aren't cheap either:
Still, the story for equities isn't as “black and white” as it is for bonds, Reid writes:
For equities it’s more difficult to assess partly because they are a real asset and therefore today could be a good time to buy if one felt that despite relatively high valuations, inflation may permanently increase (or better still real GDP growth) and thus lead to eventually permanently higher earnings notwithstanding any short-term negative implications of the inflationary transition.
But if you compare valuations to nominal GDP:
Current valuations are certainly stretched... We have been more expensive but we are approaching the peaks of 2000 and 2007 and are in line with the most stretched valuations from the 1930s on this metric and higher than the 1929 crash point.
Here we ought to pause. Every one of these journeys in time leads to the same fork in the road. One side leads to Mean Reversion, the other to It's Different This Time. Plenty of commentaries have gone over this same ground. Mean Reversion Way has the upper hand partly because it just makes intuitive sense. And you're always taking a bit of a risk to go down Different-This-Time Road, as longtime bear Jeremy Grantham recently (and very publicly) did. According to Grantham, Fed policy, demographics and monopoly conditions have all contributed to a low-inflation environment where profits stay secularly above-trend, justifying all these worrying valuations.
DB's Reid is willing to entertain the argument:
Currently there is some evidence that the US is one area where actual earnings have outstripped nominal growth in recent years for various reasons that include their large global players gaining excess overseas earnings (must be a zero sum game globally), a more shareholder friendly and focused culture and perhaps higher inequality and therefore more spoils to capital over labour.
But that's as far as Reid is willing to go:
History suggests all this is mean reverting over the medium to long term. If we look at more detail on the US which has the most developed history of equity data, including the longest series of earnings data through history, we can see the longer term issues with equity market valuations.
Enter the CAPE index:
The supposed inevitability of a giant correction wouldn't be so much of a concern if it weren't for the possibility that a sudden attack of mean-reversion destabilizes the financial system and with it the global economy – which, Reid writes, “seems to require such elevated asset prices.”
The issue with mean-reversion arguments is how selective they tend to be. This is not to say Reid is wrong on the above – God help us, he's probably right – but simply pointing to one set of charts over another does not necessarily make the case that markets are bound to resume their historical trends.
Consider this quite impressive chart Reid includes, showing global inflation going back to the thirteenth century:
Is that mean reversion or a secular decline in inflation volatility? You can look at the mid 20th century and argue the former, or the entire span and argue the latter.
Or consider this visual, charting current account balances over the past 60 years:
The crisis certainly threw everything out of whack. But there also appears to be a long-term trend of increasingly jagged squiggles, which coincide with the opening of the global economy and the loosening of capital restrictions.
Again, this isn't to say Reid is wrong and we shouldn't periodically freak ourselves out about equity and bond prices falling back to some historically sane levels at some point. But there's nothing inevitable about it.