The world’s two stock market Super Powers are the US and China. They could not be more different, yet both are at generational extremes. It’s old news, but the US is midst a valuation bubble and investor mania. In contrast, Chinese valuations are in a valuation hole, and unloved, yet bizarrely a bubble is being anticipated. Let’s explore all of this.
Starting with the US, the valuation extreme has been a given for a small number of years. It is not a timing indicator, but does shine a bright light on two issues. Firstly the vulnerability to sharp falls. Secondly the prospective longer term returns, which is a very big issue if you have been seduced by the “buy and hold” disciples, who will undoubtedly be over-weighting the US in their passive portfolios.
That vulnerability implies falls of 50% plus in the US. Heading in that direction, in that scale, would take it back to long term support, and also closer to average long term valuations. That will be very healthy. It will be difficult for most world markets to resist that pull, and at that point we will be working hard in real time to identify where there is relative strength, and buying opportunities.
Putting the total quantum of falls to one side, valuations also give you a great sense of prospective returns from year-to-year for some time ahead – in the absence of much other meaningful evidence (beyond the proclamations of many in my industry) it is a decent place to start.
The latest John Hussman number crunching informs us that the current valuation of the US stock market is now at a record high:
“On October 14, 2024, the U.S. equity market reached the most extreme level of valuation in history, based on the measures we find best-correlated with actual, subsequent 10-12 year returns across a century of market cycles… it exceeds every previous extreme, including 1929, 2000 and 2022.”
He continues, that “the expected 12-year average annual total return of the S&P 500 over and above Treasury bond returns… is minus 9.9% annually.” With the Treasury bond return of 4% at the moment, that appears to imply minus 5% a year for the next 12 years, on average.
You don’t have to believe this will happen. But you do need to take on board that these are the waters in which you are swimming.
John Hussman does not have a monopoly on this kind of research. Yet broadly speaking similar historical analysis by others reaches much the same conclusion. For example, the plain vanilla CAPE ratio (cyclically adjusted price earnings) is now more or less the same as 1929, but not as high as 2000. For a rational investor that makes a commitment to the US stock market a tough pill to swallow, unless you are very confident on your risk management skills e.g. applying a stop-loss.
In the 2030s someone might be writing something just like this as they reflect on the current decade:
“The ‘new era’ doctrine – that ‘good’ stocks were sound investments regardless of how high the price paid for them – was at bottom only a means of rationalizing under the title of ‘investment’ the well-nigh universal capitulation to the gambling fever. The notion that the desirability of a common stock was entirely independent of its price seems incredibly absurd. Yet the new-era theory led directly to this thesis… An alluring corollary of this principle was that making money in the stock market was now the easiest thing in the world.” [my bold]
That was Graham and Dood in 1934 trying to figure what led to the 1929 Crash, the curtain raiser for the Great Depression, and stock market falls of 89% over three years.
The evidence for the current investor mania has accumulated again in the US in recent weeks e.g. the Market Vane Bullish Consensus, CNN’s Fear And Greed index and The Investor Intelligence Advisors Survey. All are at extremes, which implies investors have no fear. However none of these are fine-tuning tools for market timing. Wave analysis can help, but that short term picture is unclear.
On balance, unless the US markets breaks decisively lower by the end of October, there might just be enough momentum to drive markets upwards to Christmas – but that is guesswork in the absence of better evidence in the very short term, while also accepting that extreme vulnerability remains a constant.
And China? The unprecedented press conference last weekend by the powerful Ministry of Finance was clear in its messaging if not yet the detail – we’re going to do loads, and if that doesn’t work we will do loads more. The Chinese stock markets are now pausing after the initial madness in late September. Nonetheless, if the right detail emerges in coming weeks, Chinese domestic investors are ready to rock’n’roll.
This is important as the 200 million domestic retail investors are central to what happens next, owning 55% of Chinese A shares. There has already been a huge rush to open new brokerage accounts, and notably the more risky margin trading accounts. There is undoubtedly a cultural gambling mentality, which also explains the extraordinary bull markets and bubbles in the past. Much commentary has focussed on the bubble and bust in 2015. My experience was that it was much more extreme in 2007 – the sort of bubble where making money was (apparently) so easy that people were giving up work to trade – this is always a great end-of-bubble signal.
After a 17-year bear market you might think Chinese investors would be wary. Apparently not. The result is that a market dominated by retail investors is already showing early signs of bubbly behaviour, enthused by promises of more bazooka action by the authorities. It is very early days, but the setup is clear.
Volatility is assured, so tread warily if you are faint of heart. For us the key is that the newly declared enthusiasm of the authorities to do whatever it takes should have put a floor under prices in their stock markets.
Turning to more sober events of the last week, headline U.K. inflation was lower than expected, triggering enthusiasm for two rate cuts by the end of the year. The U.K. stock market responded positively, despite some drag from the upcoming Budget. The domestically-focussed FTSE 250 was up, with only the Dow Jones of major markets doing better, up 1.85% (putting China to one side). The FTSE 100 does look as if it is about to break to new all-time highs, which could be propelled by a much less scary Budget than many expect, though it remains at the mercy of the US market in the days, weeks and months ahead.