Home' Trinidad and Tobago Guardian : November 21st 2013 Contents BG20 | COMMENTARY
BUSINESS GUARDIAN www.guardian.co.tt NOVEMBER 2013 • WEEK THREE
The sphinx exists in both Greek
and Egyptian mythology and
the Great Sphinx of Giza in
Egypt is, indeed, a present-
day tourist attraction. Both the
Greek and Egyptian versions
entail a creature that offers up what for most
people is an unsolvable riddle. The failure to
solve the riddle results in a penalty of some
So it is with the financial markets of the
world at this time. Last week, under the head-
line, The Greater Fool, I pointed out the path
that a market takes towards bubble territory
with "the greatest fool" being the person who
buys at the market top. The problem is that
this person is only known in hindsight.
Another cliché is that the job of a stock
market is "to climb a wall of worry". That wall
of worry represents all the things that investors
worry about and see in the news headlines.
Everything from low economic growth, rising
unemployment, wars, natural disasters, Oba-
macare, taper, government default, and the
list can go on. These are all headlines that
potentially had, and going forward, have the
power to spook the market. Overcoming these
issues of concern and moving to greater highs
are the job of a stock market rally.
The S&P 500 is up 25 per cent this year
and has hit many new highs along the way.
This means the market rose to a new high,
pulled back on some concern to then overcome
those concerns and rallied again.
Will it continue to rally with the recent bub-
ble talk just another wall of worry to overcome?
This is the riddle the market is now proposing
and one which can pay big dividends for the
participants who get it right.
On Friday last, an analyst from JP Morgan
moved their year-end target for the S&P 500
to 1825. A Piper Jeffery analyst on Yahoo
Finance is suggesting S&P 2,000 is within
reach. Do you recall analysts predictions during
the crude oil rally into 2008 of US$200 oil?
Or what about predictions of gold at US$5,000
an ounce being just over the horizon?
The fundamental story is that revenue for
S&P 500 companies grew 2.9 per cent in the
third quarter with all ten sectors reporting
revenue growth. However, only 53 per cent of
companies reporting so far posted revenues
above estimates. Earnings, on the other hand,
grew by 3.5 per cent with eight out of ten
reporting higher earnings compared to last
year. However, this 3.5 growth rate is below
the 7.2 per cent growth that was expected at
the beginning of the quarter (July 1). This
means earnings expectations have been revised
downwards during the quarter, but while this
is occurring, price to earnings multiples are
Overall this speaks to the trend I spoke of
last week about earnings growth outpacing
revenue growth and this is only possible
through cost-cutting or other measures that
are not sustainable over the long term.
Yet investors are paying a higher multiple
for future earnings today and this is quite pos-
sibly a symptom of exuberance. Is it "irrational
exuberance?" I would suggest not yet. On a
forward price to earnings basis, the S&P 500
is at around 15 times earnings. This is not
cheap by any measure, but it is not outlandishly
For context, this multiple of 15 is higher
than the five-year (13 times) and ten-year
average (14 times), but is lower than the 15-
year average (16 times). The latter period,
encompassed the Dot Com bubble of the 1990s
where the peak P/E ratio was 25 times.
Following on again from last week, appreciate
that assets are priced relative to other assets
and based on the risk-free rate. Where you
have a risk-free rate tending towards zero,
there is justification in higher valuation mul-
tiples. The problem will come when this begins
On Friday, Scotia Capital in a note suggested
that new US Federal Reserve Chairman des-
ignate, Janet Yellen "likely ensured that an
equity market crash (someday) is inevitable".
The key question is when?
The riddle of the stock market intensifies
when the outlook for interest rates is factored
in. The conventional view is that interest rates
in the US as measured by the ten-year US
Treasury have rebounded off the low and is
pushing up again to test the three per cent
level. As at last Friday, the ten- year bond was
at 2.70 per cent.
The US Fed is also expected to begin to
taper its quantitative easing program by March
of next year which many believe will confirm
the end of the 30-year bond market rally.
Recognise, though, that inflation measures
in the US have core inflation at 1.2 per cent.
Fundamentally, one expects a 200 basis point
spread on the ten-year Treasury over the
inflation rate. That suggests a ten-year that
should go no higher than 3.2 per cent under
the current inflation environment.
Appreciate that the US economy is levered
by some 350 per cent, so a small increase in
interest rates is likely to have a dispropor-
tionate negative impact on the economy.
Add to this dynamic the fact that a tighter
monetary policy can actually result in dis-
inflation, which, given inflation at 1.2 per
cent, can quickly turn to deflation.
Given that one of the key objectives of the
policy of quantitative easing was to fight
deflation and to create a level of inflation
trending towards two to 2.5 per cent it sug-
gests that the US Fed still has plenty of room
to maintain an accommodative stance.
The point is that even with tapering one
should not expect long-term rates to jump
sharply from here and it is also likely that
short term rates will remain anchored at the
zero bound for years to come.
If deflation were to set in the US, the Fed
may also have to become even more accom-
modative going forward, so the idea that
interest rates cannot return to levels seen
prior to May this year are not out of the
The deflation issue is very much a function
of economic growth in that it is likely an
economy showing robust signs of growth
would see demand pick up, and with the high
levels of liquidity in the system inflation,
should be a natural consequence.
However, despite the optimism and cheer-
leading, I would suggest that economic growth
face value. Very often the falling unemploy-
ment rate is used as the litmus test for eco-
nomic growth for the argument goes that a
lower unemployment rate means more people
working, which means more jobs being cre-
ated, resulting in more consumption and
demand in the economy.
No arguments there except to point out
that in such circumstances, it is not the
unemployment rate that matters, but rather
the employment rate. The number of people
employed to the size of the working popu-
lation is a much better measure of the strength
of an economy and where it is trending. In
the US for the past five years (since 2008),
that number is 58 per cent. In 2000, that
ratio stood at 64 per cent.
The bottom line is that the case for rising
interest rates in the US is not so clear cut.
In such circumstances, risk assets, such as
stocks, should continue to do well. The prob-
lem is that with earnings and revenue growth
rates below the rate of stock price appreci-
ation, gains are coming from price to earnings
The longer this goes on for, the less sus-
tainable it will be. Markets have been on a
nice rally providing excellent returns to
Many have not participated out of a con-
tinued fear from 2008 and also because they
have fallen victim to the "wall of worry" that
comes from reading the news headlines.
This is why you need a professional finan-
cial adviser to take the emotion out of the
investing equation. However, there is now
the risk of another emotion coming into the
mix. That emotion is exuberance. Markets
have been on a run and everyone is making
money, which means everyone is an expert.
Once again, the hubris of "I can do this
myself" sets into the mix.
There are risks which one would do well
to ensure are managed in a professional man-
ner. You can try to figure it out yourself and
follow the trend of the market. Just remember
that high valuations can go even higher. That
is not to say the market will announce when
it is overvalued. When will the music stop?
Remember the fate of those who could not
solve the riddle of the sphinx.
Ian Narine is a broker registered with the
Securities and Exchange Commission.
The riddle of the sphinx
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