If anything, the current turmoil and its impact on credit markets and confidence could have the effect of bring on another rate cut next month in Australia next month, says the AMP’s chief economist and strategist, Dr Shane Oliver.
He says that with financial turmoil intensifying again, various commentators have been making comparisons to the 1930s, shares have been hitting new bear market lows (Australian shares are now down 34% from last November’s high, US shares down 24% and Asian shares are off 40%) and the global economy looking more and more shaky.
"Its easy to get very bearish, with predictions of a long term bear market based on an unwinding of household debt levels and slump in consumer spending made worse by the credit crunch becoming more common.
"For some time we have been of the view that shares would remain weak into September/October ahead of better conditions later this year and going into 2009.
While the ongoing turmoil in the US financial system indicates that the risks have gone up and that shares may see further downside in the next month or so, our assessment is that a long term bear market in shares is unlikely," he says.
With financial turmoil in the US intensifying again on the back of Lehman Brothers failure and concerns about other companies, claims that the current situation is the worst since the 1930s, shares making new bear market lows and the global economy continuing to deteriorate its easy to get very bearish. In fact there are many who argue shares are now in a long term bear market led by an unravelling of debt, asset prices, consumer spending and profits.
This note reviews the main issues and why we think such a long term bear market is unlikely.
The long term Bear case
Most predictions of a long term bear market in shares focus on the US. Firstly, it’s argued that shares may not be overvalued relative to the current level of company profits but there has been an unsustainable bubble in profits and if this is adjusted for shares are expensive.
One way of doing this, popularised by Robert Shiller in his book Irrational Exuberance, is to compare shares to a trailing ten year average of earnings and when this is done the price to earnings ratio (PE) for US shares is still above its very long term average, and it usually overshoots below its long term average. The next chart shows this for the US.
Secondly, it’s claimed by the long term bears that the bubble in profits has been fuelled in large part by a housing bubble in the US and other key countries including Australia which in turn has been underpinned by a massive rise in household debt levels (see the next chart) which has all resulted in a consumer spending spree.
Finally, the perma bears argue that thanks to the US subprime crisis and resulting credit crunch the housing bubble is now bursting and this has set off a debt deflation spiral like Japan experienced in the 1990s and the US in the 1930s.
This would run something like this: falling house prices result in loss of wealth and reduced consumer spending which results in tougher economic conditions which results in rising mortgage defaults and less demand for houses and reduced bank lending in response to their mortgage losses which results in further falls in house prices and so on.
It’s claimed that the US and UK are already embarking along this debt deflation spiral – only made worse by the latest bout of financial market turmoil – and that Australia is just starting.
As a result, the long term bears argue that the bear market in shares has only just begun. This all raises several issues.
What is an appropriate long term PE?
There are several reasons to believe that the appropriate PE has moved up over time.
Share markets today are highly liquid, transaction costs are very low and it is easy to set up a diversified portfolio to reduce risk.
And the volatility of economic activity and wages has declined dramatically over the last century which should result in a higher level of investor risk tolerance.
These considerations suggest investors would be happy to buy shares on a higher PE today than was case in the distant past and as a result the fair value PE today is likely to be higher than it was in 1900 or 1950.
If this is the case it would mean that even after smoothing out the surge in profits over the last few years shares are still not expensive.
Has there really been a bubble in earnings?
There is no doubt that the level of earnings increased at an unsustainable pace in recent years on the back of strong productivity growth, more flexible labour markets and the resources boom in Australia’s case.
This has taken margins and profit shares of GDP up to record levels as evident in the chart below for the US and Australia.
While its to be expected that the profit share will fall back a bit as is already occurring in the US and that the long term profit growth will slow to a more sustainable pace there is no reason to expect the profit share of GDP to collapse: the sort of wages pressure that result in profit collapses didn’t eventuate through the 2002 to 2007 global economic recovery & look unlikely now economic activity is slowing.
What is the risk of a debt deflation spiral?
The risk of debt deflation spiral is significant, particularly in the US and UK where house prices are already falling sharply, banks and other financial institutions have sustained big losses with several going bust in t
