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BW Businessworld

A Forecast On Global Equity

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Why do asset bubbles occur? Normally because of widespread denial and not due to a lack of clear indications. Thinking back to the times of the dotcom crash, the  Standard &Poor'S&P 500 was trading at almost 30x trailing earnings, slightly less than double its historic mean. Back then, experts explained it with the fast penetration of Internet in all sectors of life, which led to the slight misinterpretation that cash burn rates and revenue/share price multiples are better indicators of a company´s well-being than profitability ratios. In late 2006, before the 40+ per cent decline in US housing prices, the ratio of prices to rents was double the 'old normal', well reasoned again by experts who claimed that it occurred due to Fanny and Freddie´s generous financing (mal-)practices, governmental subsidies and, thanks to Alan Greenspan, low interest rates.

This time is different? Well, Rogoff´s and Reinhart´s publication in late 2009 should have disillusioned our hopes of paradigm shifts in the avoidance of bubble/bust cycles in economies and markets. It is still not different. Why? Let´s take a closer look at the V-shape recoveries of western stock markets and if they show signs of overheating.

In filtering the most impacting factors on global stock market performances, the US consumer´s recovery and the sustainability of China´s growth path need to be top ranked.

Let us examine the pulse of the US consumer. Listening to financial heads talk on big media channels, one would believe that the spin of "reasonably valued stocks" is due to an impressive turnaround in margins and earnings of, in particular, larger corporations. Even if a new equity bubble is arising at the horizon, the signs for it are less obvious.

However, going beyond main stream sentiment, is always worth the effort. Taking the S&P 500 current price-to-earnings ratio (PER), trailing earnings, of 15x, we now trade at levels slightly above the 14.6x of its historic mean. Reasonably priced? Applying the more realistic Shiller PER (based on average inflation-adjusted earnings from the previous 10 years), we find a fundamentally different picture. The current Shiller PER of 24x, has only been higher twice; before the Great Depression and at the peak of the dotcom boom. A statistical outlier? Let´s dig deeper. An economy with a GDP still relying on consumption at close to 70 per cent requires a consumer that participates in the creation of wealth. Otherwise the equation is not satisfied. The 'real median household income' doesn´t mince the message: no increase in over 14 years. Is the consumer at least deleveraged, after the roller-coaster real-estate ride during the last cycle? No, not even mean reverted. CoreLogic´s latest release for Q4/2010 sees more than 23 per cent of all mortgages in negative equity!

How can we expect the US consumer leading the economy out of the muddle through periods of sluggish growth, turning around the housing market and, as a consequence, justifying higher equity prices, when neither the participation rate in the US job market, nor the wages paid for work are supporting a sustainable recovery?

No wonder, Ben Bernanke felt pressurised in August 2010 to announce QE II, compensating for President Obama´s lack of political capital for a second stimulus (Bush tax cut extensions in late 2010 had a marginal effect on the economy). Did the soon to end QE II at least work? Bernanke´s goal to stimulate Main Street activities expanded the central bank´s balance sheet to $ 2.72 trn (or about 18 per cent of US GDP). In the official M3 money supply was shrinking until spring 2011 since the outbreak of financial crisis. The Fed´s activities might not have helped the Main Street recover (US GDP growth in Q1/11 has been marginal at +0.4 per cent QoQ (quarter on quarter), compared to Germany´s +1.5 per cent QoQ), but successfully fought deflationary pressure. We can call it consolation money.

In short, the current state of the US consumer doesn´t justify the market´s assumption of a sustainable economic recovery.

The 'Sustainable' Chinese Growth Path
Is China the last man standing? Not so much. Since the Chinese Vice Prime Minister Li Keqiang admitted that "man-made" GDP numbers that are "for reference only" (WikiLeaks, 2007 cable, published Jan11), we now officially know what to do with those numbers; ignore them. He himself recommended that it is better to measure the country's economic health via electricity consumption and similar second and third row indicators. How can we refuse the advice of a high ranked party member? Electricity consumption increased in 2010 by 14 per cent, indicating stronger growth of the economy than the GDP numbers tell. Interestingly, the quarterly growth pattern has shown a significant slowdown during 2010. Starting with +22.7 per cent in Q1, the year ended with only +5.5 per cent.



China´s gross fixed capital formation was close to 50 per cent towards the end of 2010, which indicated significant overcapacity not only in real estate but sectors as well. Also, the rise of inflation is clearly not under control yet. Instead, the National Bureau of Statistics has reduced the weighting of food prices in the CPI basket as per 1January 2011, to lower the official inflation numbers. Statistical tricks might do the job for some time to keep the public quiet. Global investors should however be warned by these red flags.

Conclusion
Equity investors beware of the market´s confidence in the US consumer and Chinese short term strength. Emerging market indices are down 20+ per cent from their post-crisis highs. The flow of funds for Q1/11 reports an outflow from emerging economies, back to the old world´s equity markets. But even this assumption is built on sand. We are bearish on global equity for the second half of 2011.

Markus Schuller is a professor of Finance at International University of Monaco. He is the founder of Panthera Solutions , an alternative investment consultancy in the Principality of Monaco