Everyone Went All In As The World Set Up For The Unwinding Of Three Mega-Trends, And Nearly Seven In 10 Investors Say Stocks Are Overvalued
Stephen Roach says the world is set up for the unwinding of three mega-trends: unconventional monetary policy, the real economy’s dependence on assets, and a potentially destabilizing global saving arbitrage
After years of post-crisis despair, the broad consensus of forecasters is now quite upbeat about prospects for the global economy in 2018. World GDP growth is viewed as increasingly strong, synchronous, and inflation-free. Exuberant financial markets could hardly ask for more.
While I have great respect for the forecasting community and the collective wisdom of financial markets, I suspect that today’s consensus of complacency will be seriously tested in 2018. The test might come from a shock – especially in view of the rising risk of a hot war (with North Korea) or a trade war (between the US and China) or a collapsing asset bubble (think Bitcoin). But I have a hunch it will turn out to be something far more systemic.
The world is set up for the unwinding of three mega-trends: unconventional monetary policy, the real economy’s dependence on assets, and a potentially destabilizing global saving arbitrage. At risk are the very fundamentals that underpin current optimism. One or more of these pillars of complacency will, I suspect, crumble in 2018.
Unfortunately, the die has long been cast for this moment of reckoning. Afflicted by a profound sense of amnesia, central banks have repeated the same mistake they made in the pre-crisis froth of 2003-2007 – maintaining excessively accommodative monetary policies for too long. Misguided by inflation targeting in an inflationless world, monetary authorities have deferred policy normalization for far too long.
That now appears to be changing, but only grudgingly. If anything, central bankers are signaling that the coming normalization may even be more glacial than that of the mid-2000s. After all, with inflation still undershooting, goes the argument, what’s the rush?
Alas, there is an important twist today that wasn’t in play back then –central banks’ swollen balance sheets. From 2008 to 2017, the combined asset holdings of central banks in the major advanced economies (the United States, the eurozone, and Japan) expanded by $8.3 trillion, according to the Bank for International Settlements. With nominal GDP in these same economies increasing by just $2.1 trillion over the same period, the remaining $6.2 trillion of excess liquidity has distorted asset prices around the world.
Therein lies the crux of the problem. Real economies have been artificially propped up by these distorted asset prices, and glacial normalization will only prolong this dependency. Yet when central banks’ balance sheets finally start to shrink, asset-dependent economies will once again be in peril. And the risks are likely to be far more serious today than a decade ago, owing not only to the overhang of swollen central bank balance sheets, but also to the overvaluation of assets.
That is particularly true in the United States. According to Nobel laureate economist Robert J. Shiller, the cyclically adjusted price-earnings (CAPE) ratio of 31.3 is currently about 15% higher than it was in mid-2007, on the brink of the subprime crisis. In fact, the CAPE ratio has been higher than it is today only twice in its 135-plus year history – in 1929 and in 2000. Those are not comforting precedents.
As was evident in both 2000 and 2008, it doesn’t take much for overvalued asset markets to fall sharply. That’s where the third mega-trend could come into play – a wrenching adjustment in the global saving mix. In this case, it’s all about China and the US – the polar extremes of the world’s saving distribution.Article Continues Below
Investors Are the Most Bearish Since Great Financial Crisis
Nearly seven in 10 investors say stocks are overvalued
For years, the historic run higher for U.S. stocks has been characterized as a “hated” rally, one that has consistently vexed investors with rising prices in the face of widespread skepticism.
If anything, repeated record highs in 2017 have only made money managers more dour.
Big investors are heading into 2018 with the most bearish perspective on stocks since the great financial crisis, according to Boston Consulting Group’s annual investor survey.
Fully 46% of investors were pessimistic about equity markets for the next year, up from 32% a year ago and 19% in 2015; more than one-third were bearish about stocks over three years, more than double last year.
As global equity benchmarks have rallied, more investors see the market as richly valued. Fully 68% of respondents said the equity market is “overvalued,” more than double the 29% of respondents who thought as much last year.
There is a fascinating table in JPMorgan’s 2018 year-end outlook released overnight, previewed yesterday by head quant Marko Kolanovic: it shows that a funny thing happened as the so-called experts were looking for signs of retail euphoria (and repeatedly were unable to find it): everyone went “all-in” stocks, and not just retail investors and US households, but mutual funds, hedge funds, pensions, systematic, and sovereign wealth funds.
The table below breaks down equity positioning in percentile terms by investor type: it shows that never investors have never been more long equities, or more “all-in” stocks.
As JPMorgan calculated first one month ago when looking at the equity positioning of the main investor types, “allocations are near historical highs, not leaving much room for further increases.” How historic? The bank explains:
Starting with retail investors one can notice that margin debt (measured as percentage of market capitalization) is at its highest point ever, which includes the 2000 tech bubble episode. The percentage of US household wealth in equities is in its 94th percentile and above its 2007 peak, but slightly below 2000 levels. Sovereign wealth funds and US mutual funds are also near record levels. Pension Fund allocations appear to be in the 88% percentile, although there is some uncertainty around this number in adjusting for private asset and HF holdings. Global Hedge Funds’ allocation (as measured by equity beta) are also near record highs, and Equity Hedge funds’ allocation in their 93rd percentile (since 2005).
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