Virtually all the risks that equity investors face now is that they confront other asset classes as well. Photo / Getty Images
Virtually all the risks that equity investors face now is that they confront other asset classes as well. Photo / Getty Images
Roger Bootle is chairman of Capital Economics
A number of analysts think that global equities are significantly overvalued. Some even fear an impending stock market crash. It is easy to appreciate why this might be.
Over recent years, the world's central banks have poured money into the system in an effort to boost aggregate demand and hence keep the economy growing after the financial crisis of 2007 to 2009 and the subsequent Great Recession.
It was explicitly envisaged that this would work through boosting asset prices. Now this policy is coming to an end.
The US Fed some time ago stopped buying more bonds and is allowing its holdings gradually to run down as bonds mature, while the Bank of England has stopped increasing its bond holdings.
But according to some yardsticks they look anything but. The most widely watched bearish indicator is the so-called "CAPE", standing for the "cyclically adjusted price-earnings ratio".
This measure has been advocated and popularised by the Nobel Prize winning economist, Robert Shiller.
It is different from the standard P/E ratio in that it uses a 10-year average of corporate earnings, rather than earnings over the latest 12 months. This averaging is designed to counter the influence of the economic cycle on earnings.
Recent readings of the CAPE in the US, using the S&P stockmarket index, give alarming results. It currently stands at over 31. In its long history, going back to the late 1880s, it has only once been higher - just before the bursting of the dotcom bubble in 1999.
And it was about the current level just before the Great Crash in 1929. This does not exactly inspire confidence in today's values and seems to back up all those who think that a crash is likely.
But this measure should not be accepted blindly.
Precisely because it uses a 10-year average of earnings, it includes years during and immediately after the Great Recession when corporate earnings were unusually depressed.
If instead you measure the P/E ratio using analysts' forecasts for forward operating earnings, then the P/E ratio comes out at about 17.4.
CAPE ratios in most European markets, including the UK, are nothing like as elevated as the US equivalent.
And if you make a comparison between stockmarkets in dollars, you find that whereas in the past 12 months the US market has risen by 14 per cent, the UK's FTSE 100 has risen by only about 7 per cent. The FTSE 100's under-performance makes UK stocks look comparatively good value.
Nor is the argument about the end of monetary stimulus overpowering.
There are doubts about just how effective quantitative easing has been. If it has not been that effective, then the end of QE, as long as it does not take place abruptly, should not cause a major adverse effect either.
This is particularly so since it has been so well telegraphed in advance. On the whole, things that cause major disturbances in the market are shocks.
The end of QE can hardly be described as a shock.
In my view, much more important than QE, both for the economy and for asset prices, has been the policy of ultra-low, short-term interest rates.
Rates are set to continue to rise and this cannot be a helpful development for asset values.
Having said that, as long as they don't rise much faster than the market currently expects then the effects are unlikely to be dramatic.
Again, future rises in rates have been well telegraphed, with the next increase in US rates likely to happen this week.
US bond yields already embody the expectation of higher rates with 10-year yields hovering around 3 per cent, even though the official short-term interest rate is only 1.5 per cent to 1.75 per cent.
Equities will take a severe beating if inflation rises significantly and can only be brought down by a period of high real interest rates. Photo / AP
What are the major risks that could upset the apple cart? The two leading ones are a severe economic downturn with accompanied weakness of corporate earnings, and a greater than expected rise in short-term interest rates that then leads to a rise in bond yields.
Fortunately, although both of these risks deserve serious consideration, they are unlikely to occur together. If the economy does slow considerably, both in the UK and in the US, the result is likely to be lower rates and lower bond yields than would have otherwise occurred.
The one case where both things go wrong simultaneously is when inflation rises significantly and can only be brought down by a period of high real interest rates.
In these circumstances, equities would take a severe beating as they would be hit simultaneously by worse prospects for corporate earnings, and an adverse turn in investors' required P/E ratio in response to higher bond yields.
There are also a fair few geopolitical risks: a trade war; a shooting war in the Middle East, or with North Korea, China or Russia; political instability in the EU; and the possible impeachment of US President Donald Trump.
Each of these is a serious risk. It is tempting to believe that such risks are more worrying now than they have been before, but I have never known a time when investors believed that the current conjuncture was unusually certain and risk free.
The striking thing about virtually all the risks that equity investors face now is that they confront other asset classes as well.
I am left with the conclusion that we may be in one of those phases when there is no major asset class that offers clearly good value. But I don't think that UK equities are in a bubble. They may not be cheap but nor do they look horrendously expensive.
