Our view continues to be that the stock market has been forming a long top.  While markets in Europe, Japan and the emerging economies have fallen about 20% from their 2015 highs, the S&P500 Index has come close to a new all-time high three times over the past 13 month, but has been unable to surpass it because valuations are high.  Will the 4th attempt be any more successful?  The problem in our view is that the underlying fundamentals of the stock market; corporate earnings, economic growth and stock valuations, remain bearish.  While the passage of time has taken some of the teeth out of the bear case as investors had worried about missing out on a rising stock market and a long-awaited recovery in the beaten-down commodities sector, the S&P500 is trading at one of its highest multiples since 2004. Using the cyclically adjusted price-earnings ratio developed by Robert Shiller based on 10 years of earnings, the S&P500 fetches a valuation of more than 26, way above its 135-year average of 16.6.

Also, the World Bank is reducing its forecast for the global economy this year — again.  The aid agency now predicts that growth will reach 2.4% this year, down from the 2.9% it had seen in January and unchanged from 2015.  The U.S. economy is forecast to grow 1.9%, down from 2.4% in 2015.  The Eurozone is expected to grow 1.6%, the same as last year.   It also slashed its forecast for Japan’s growth to 0.5% from the 1.3% it expected in January.  Its forecast for China remained 6.7%.  So despite all the impetus from the aggressive action from central banks, growth continues to be tepid, probably in large part due to the large debt overhang and the lack of business investment spending.

The level of desperation of central banks to stimulate growth with low interest rates has taken a step further in the past year as interest rates are now negative for over US$10 trillion of global debt, including bonds in Japan, Germany and Switzerland.  For those unfamiliar with the concept of negative rates, it basically means that investors are willing to effectively pay banks to borrow money from them.  What does this tell us about the psychology of global risk taking right now when an investor is willing to lend the German government $1,000 for ten years and take back only $980 at the end of that period and receive no other income along the way?  And how can we reconcile that with stock market investors who have pushed U.S. stocks back close to their all-time highs?  Clearly a dichotomy has developed.  If we really are in a period of ‘deflation’, then the last time a major economy went through such a period was Japan in the 1990’s or the U.S. in the 1930’s.  History shows that those periods were not kind to stock market investors.   Why should we expect this version to be any different?

Negative Interest Rates: Germany & Japan

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