One important indicator suggests that global equities are in a bubble.
I’m thinking of the ratio of the money stock to share prices in developed economies. Common sense says this should matter. If investors own lots of cash relative to equities, it’s a sign that the latter are cheap and that any rebalancing of portfolios is more likely to be from cash into shares than vice versa, which would drive prices up. By the same token, if the ratio of equities to cash is high it is a sign that shares are over-owned and so markets are in danger of falling.
Sadly, there’s a slight complication to this common sense. The ratio of money to prices has trended upwards over time: in the last 30 years the broad money stock in The Organisation for Economic Co-operation and Development (OECD) countries has risen 8.1 per cent a year compared with a rise of 6.3 per cent a year in MSCI’s world index. You might think such strong demand for cash is odd at a time when interest rates have trended down. It’s not. Rates have fallen precisely because there has for years been strong demand for safe assets – not just for bonds but for cash as well.
It’s easy to adjust for this trend. My chart does so. And it shows that this detrended ratio does a good job of predicting returns. High money-price ratios in 2003 and 2009 led to the market rising strongly in the following three years, while low ratios in 2000, 2006 and 2014 led to prices falling. The ratios also predicts annual changes in the MSCI world index (albeit slightly less well) and moves in the All-Share index, because UK shares rise and fall as global ones do.
Granted, this predictive power might not be because the money-price ratio predicts flows between money and equities. It might instead simply be that shares overreact on both the upside and downside and so sometimes become too expensive or too cheap. When this happens, the ratio of prices to anything with a stable upward trend will tell us that the market is cheap or dear and so predict returns: it could be money or dividends or GDP or just a time trend.
No matter. What matters is what works. And the money-price ratio works. Given that our knowledge of the future is naturally limited, this is useful.
The ratio has not, however, always performed well. In the late 1990s, it told us that shares were expensive or over-owned relative to cash. But they became even more expensive and more over-owned as investors bought into stories about the growth of a new economy and so pushed tech stocks ever higher.
In retrospect, we now know that was a bubble. Eventually, the money-price ratio was correct to warn us the market would fall.
Which brings us to our problem. There is now a similar disconnect between the money-price ratio and global equities. Three years ago, the money-price ratio predicted that the MSCI index would have fallen slightly between then and now. In fact, it is up by over 40 per cent.
Of course, this time might be different. Perhaps the rising valuations of big US tech shares are sustainable now in a way they were not in the late 1990s – though if they are, it is because monopoly power is entrenched which is hardly a sign of a healthy economy.
But there’s another possibility – that equities have been inflated by irrational exuberance and ultra-low interest rates, neither of which are sustainable. The fact that the Nasdaq index fell last week as US bond yields edged up is a warning that shares are fragile to higher rates. Whether this is because they have been inflated by cheap money or by low bond yields reducing the discount rate applied to future earnings is irrelevant. The conclusion is the same – that equities are vulnerable.
This does not mean a crash is imminent. Even if equities are over valued, they can become more so in the near term: the money-price ratio, like other predictors of returns, only works over longer time horizons. And the lesson of the tech crash is that bubbles deflate only slowly.
From this perspective, the UK market is relatively attractive. Its comparatively low valuations – the result of there being few large growth stocks here – mean it is resilient to higher bond yields or deflating valuations.
But only relatively resilient. When the world market falls significantly, so too do most equities. The best we can hope for is that the UK would fall by less.
There is, therefore, a threat to global equities. This doesn’t mean we must rush out to sell, not least because other indicators such as the ratio of retail sales to the All-Share index are more bullish. But it does justify caution. And those who are in the market need to have some kind of exit strategy.
