Watch how sentiment could sway the markets

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While the FTSE 100's advance toward and then beyond its 1999 all-time high of 6,930 continues to attract headlines, another famous benchmark is making a dash to reach its own prior peak, reached fifteen years ago almost to the day. The NASDAQ Composite topped out at 5,048 on 10 March 2000 and at the time of writing America's technology-laden benchmark has reached 4,994.

The NASDAQ Composite is the next index to near its prior all-time high

The NASDAQ Composite is the next index to near its prior all-time high

Source: Thomson Reuters Datastream

The timing of the NASDAQ's assault on its high is appropriate in some ways as the World Mobile Congress in Barcelona draws to a close. The annual jamboree showcases the latest hardware and software developments in the field of mobile telecommunications and much of this year's themes and events hark back to the giddy days of the technology, telecoms and media (TMT) bubble of the late 1990s. Much of what was anticipated back then did come to pass (and frankly a lot more besides) – it just did so a lot more slowly than the market had hoped, leaving valuations looking overstretched and equity investors with no margin of safety when profits (or even revenues) failed to materialise on time.

Advisers and their clients must always beware of the 'hype cycle' when it comes to areas such as technology and biotechnology. These areas will often overdeliver relative to expectations in the long run but they can easily disappoint in the short term and for a company to make money it must have a first-mover advantage or at least be ranked top-three by market share – the also-rans tend to make losses and go out of business after a long struggle.

Investors and clients must be wary of the Hype Cycle

Investors and clients must be wary of the Hype Cycle

Source: Gartner Group

Any disappointment when it comes to the timing of product delivery, orders, sales or income can result in crunching share price falls – as evidenced by the NASDAQ's 2000 to 2003 collapse and the FTSE 100's plunge at the same time, as the UK's own benchmark had over 20 TMT names in it just as the bubble popped.

The question of whether profits and cashflows can justify valuations remains as relevant today, for the NASDAQ and indeed the US and UK equity markets overall. Technology may lie at the heart of whether the markets should be where they are, or whether they are terribly overcooked. This is because US corporate profits as a percentage of GDP are at an all-time high, as also they appear to be in the UK (albeit at a lower level).

Technology-led productivity lies at the heart of this according to supporters of US stocks, as America continues to show the dynamic, entrepreneurial spirit which typifies it economy and deep financial markets. Sceptics argue it cannot – will not – last and that investors in US stocks are in for a shock, especially as profits growth is slowing and economic indicators remain mixed.

The rogue element here remains central bank policy, in the form of record low interest rates and the wave of liquidity created by the Quantitative Easing programmes in Japan and Europe. Cash is being forced into riskier assets, such as stocks, whether it likes it or not, as the reach for income and premium returns remains acute. Valuation on its own never calls the top of a market, as an expensive asset can keep going for a long time (as TMT stocks proved in 1999).

The trick is spotting what changes perception of that valuation – and it is usually a sustained run of earnings disappointments - so advisers and clients need to keep a close eye on profits momentum and the economic factors which helps to drive it, especially Stateside.

On the money

According to figures from Thomson Reuters Datastream the FTSE All-Share is trading on around 17 times earnings. This is bang on its historic average and as such hardly seems like cause for undue alarm, especially as history shows it is quite capable of overshooting to the upside if earnings momentum is strong enough.

UK equities trade in line with their historic valuation averages

UK equities trade in line with their historic valuation averages

Source: Thomson Reuters Datastream, AJ Bell Research

The next chart shows the year-on-year change aggregate in UK corporate earnings – according to the Office for National Statistics – but also company earnings as a percentage of GDP.

There has been gradual improvement over time in UK plc's earnings power to around 6% of GDP, but there is nothing to suggest any of these numbers differ too much from historic norms. If there is a worry it is that profits growth is retreating to near zero.

year-on-year change aggregate in UK corporate earnings

Source: Thomson Reuters Datastream, ONS, AJ Bell Research

Brave new world

The picture in the US is very different – and therefore more interesting.

This next graphic shows American corporate profits growth and corporate profits as a percentage of GDP.

The picture in the US is very different – and therefore more interesting.

Source: Thomson Reuters Datastream, AJ Bell Research

As with the UK, the growth picture is of some concern, as momentum is fading.

Of greater issuer is the other line, which shows US corporate earnings at some 13% of GDP – way above historic norms and the 4% to 8% range which characterised the Eighties, Nineties and Noughties.

Bulls will argue this is all down to productivity, ruthless cost-cutting and investment in state-of-the-art technology. Cynics counter by saying it may be down to inequality, poor wage inflation and even lack of investment in an attempt to flatter short term earnings. Whichever camp is correct, the increase is as remarkable as it is undeniable.

This stunning increase in profitability becomes all the more important when it is linked to the issue of US equity valuations. One – but by no means the only – barometer here is the Cyclically Adjusted Price to Earnings Ratio (CAPE) multiple devised and tracked by Professor Robert Shiller. It shows US stocks have only been more expensive in their history on a handful of occasions, including 1929 and 2000, when disaster struck.

Cyclically Adjusted Price to Earnings Ratio

Source: http://www.econ.yale.edu/~shiller/data.htm

CAPE has its challengers. Some will argue Shiller uses a 10-year historic rolling-average earnings figure, so the current profit calculation captures the 2007-09 downturn, which was very deep indeed. Others will question the relevance of comparing data from the 1880s to this decade and whether the long-run average of 17 times earnings on CAPE is useful (although the multiple post 1980 is still 'only' 21 times).

Bulls had better hope not, given the current CAPE rating is 27 times, as a literal interpretation is the US market could fall 40% and be only fairly valued, relative to its history. And that, remember, is 27 times a record high figure for US firms in terms of their profits. Heaven help their share prices if American companies were to mean revert to the 6% of GDP range and their ratings were to normalise too. In crude terms the S&P 500 could fall by around 70% under such a scenario.

Watch the data

In crude terms the S&P 500 could fall by around 70% under such a scenario. Even if that seems unlikely now, premium earnings and good momentum are required to sustain valuations, even in world where zero interest rates act as a sturdy prop. Again, market accidents occur at a time when earnings and valuations tend to be running above historic norms trend and disappointment then intrudes (though a careful look at Shiller's figures show the 1987 Crash came off a multiple of 16 times, compared to in 25 times in 1901, 33 times 1929 and in 44 times in 2000).

The good news is the US economy still seems to be ticking along, judging by guides such as unemployment and employment, as well as headline GDP numbers, despite February's downward revision to the fourth quarter's rate of progress in 2014 from 2.6% to 2.2%.

Yet advisers may take heed of other signals. Jobs data are by their very nature backward-looking and lagging indicators, as are GDP numbers. Bond yields (sinking again) and commodity prices (in the dog house) are historically fair guides, while sentiment indicators can flag shifts in momentum.

The short-term numbers in the US are noisy, owing to rotten winter weather and strikes at key West Coast ports. But it may be unwise to dismiss the following selection of manufacturing sentiment indicators from the New York, Dallas, Richmond and Philadelphia Federal Reserve districts, as well as sudden slumps in the New York and Chicago Purchasing Managers' Indices. If they go – and stay – below 50 there could be a bump coming, even if any market retreat could easily tempt the US Federal Reserve to hold off on interest rate rises, or even return to its QE programme.

The Empire State manufacturing survey could to snap back...

The Empire State manufacturing survey could to snap back...

Source: Thomson Reuters Datastream

...As Philly Fed survey takes on a dour look...

...As Philly Fed survey takes on a dour look...

Source: Thomson Reuters Datastream

...the Dallas Fed survey looks far from slick...

...the Dallas Fed survey looks far from slick...

Source: Thomson Reuters Datastream

...the Richmond Fed survey rolls over...

...the Richmond Fed survey rolls over...

Source: Thomson Reuters Datastream

...and purchasing managers indices from New York and Chicago slump...

...and purchasing managers indices from New York and Chicago slump...

Source: Thomson Reuters Datastream

Russ Mould, AJ Bell Investment Director


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Written by:
Russ Mould

Russ Mould has 28 years' experience of the capital markets. He started at Scottish Equitable in 1991 as a fund manager and in 1993 he joined SG Warburg, now part of UBS investment bank, where he worked as equity analyst covering the technology sector for 12 years. Russ joined Shares in November 2005 as technology correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media by AJ Bell Group, he was appointed AJ Bell’s Investment Director in summer 2013.