Ageing bull

Buttonwood

Dec 7th 2006 | NEW YORK
From The Economist print edition

With few places left to turn, investors have pinned their hopes on the stockmarket

ROCKY is returning to American cinemas this Christmas. And the financial markets increasingly resemble Sylvester Stallone's ageing pugilist: they may get knocked aecout a bit, but they always seem to bounce back.

In recent weeks disappointing economic data have pointed to the possibility of an American recession in 2007. The dollar has weakened sharply, raising the spectre of the complete collapse that bears have been predicting for years. And on December 4th Pfizer, the pharmaceuticals giant, saw its share price plunge after yet another drug failed the testing process (see article).

But the stockmarket has rolled with the punches. And other asset classes have been similarly buoyant. The spreads (extra yields) on corporate bonds and emerging-market debt are low by historical standards; commercial-property valuations in America and Britain are high.

The general explanation for this bullishness is that the world is flush with liquidity. But liquidity is one of those catchall phrases that is not as good as it sounds—a bit like saying “there are more buyers than sellers”, which is itself a cliché of dubious merit (for every buyer who makes a trade, there must be a seller).

What does appear to be clear is that investors are happy to take on risk and eager to buy any asset that offers a higher yield than government bonds. And even those investors who do worry about the American recovery, or about political risks in the Middle East, have to think twice before they sell. The corporate sector is still increasing profits and churning out cash in the form of dividends and share buy-backs. Every Monday seems to bring news of a mega-merger; on December 4th, it was the combination of Bank of New York and Mellon Financial (see article). Potential bid targets from the private-equity sector get larger and larger (the latest tittle-tattle is about Home Depot, worth over $100 billion if you throw in debt). Why sell your shares if someone might be willing to buy them tomorrow at a 20% premium?

As for the dollar, the reason to worry would be if a falling currency prompted foreign investors to demand higher yields on American Treasury bonds to compensate them for the risk. That might really push America into recession. But it is not happening so far; yields have been falling.

All this adds up to what Jim Cramer, the hyperactive pundit of American financial television, describes as “one of the best markets I've ever seen.” Bulls are talking about double-digit stockmarket returns in 2007, thanks to a combination of stockmarket rerating (higher price-earnings multiple) and growing profits.

So what might spoil the party? One problem, as the producers of the Rocky series know only too well, is that sequels are subject to the laws of diminishing returns. Once bond spreads and property yields are low, there is no longer much scope for further capital gains.

That is why investors' hopes are pinned on the stockmarket in 2007; share valuations are only at historically average levels. But company profits are at a 40-year high as a share of American GDP. If profits were about to revert to the mean, share multiples should fall below average.

The bulls do not think that will happen soon. But whereas one more year of above-average profits growth is possible, three or four more are hard to imagine.

Clearly, the use of borrowed money to enhance returns (often referred to as the “carry trade”) means that the markets are vulnerable to a change in sentiment. When the trend changes, as it did in May, there will be a mad rush for the exits. As Bill Gross of Pimco, a bond giant, writes: “I have a strong sense that the ability to lever any or all asset returns via increasing leverage is reaching a climax.”

Timing, however, is notoriously difficult. Bears can point to low share volatility, as measured by the Chicago Board Options Exchange's VIX gauge, as a sign of investor complacency. But it may merely be that investors have seen no need to incur the costs of insuring their portfolios against loss.

The markets will thus need some sort of shove to push them off today's course. Higher unemployment would be one possibility: it might turn the housing-market correction into a rout. If the nuclear dispute with Iran were to escalate so that, say, the straits of Hormuz were blocked and crude jumped to $100 a barrel, investor confidence would take a hit.

But predicting such events is more in the realms of astrology than financial punditry. Sceptical fund managers have been forced into a position of being “fully invested and scared as hell.” The knockout blow will undoubtedly come (probably in the credit markets). But just like the Rocky franchise, bull runs on financial markets have a habit of going on much longer than most people expect.