At the end of 2013, analysts (including their own) were overly-confident that the market would continue rising forever. They remind us that “corrections are born of complacency.” There was too much back-slapping and not enough hand-wringing, which is always worrisome.
They looked at the relationship between forward price-earnings ratios and rising interest rates. Right now, that ratio is 15.7X, compared to a historical average of 13.8X since 1976. They plotted that ratio against real long-term Treasury yields and found that the ratio can continue rising until it passes 4%. My reaction is that it is interesting — but too little history to produce too firm a rule. Also, one reason interest rates rise is because the economy is improving, which increases the demand for money and therefore the price of money or interest rates, and the rise in stock prices will continue until such time as the pain of increased interest rates begin. In other words, there is a time lag that should be included in their discussion.
A good sign is that companies are starting to re-invest their cash into their businesses rather than return it to shareholders. In other words, CEOs are starting to see real opportunities. Right now, 84% of the companies in the S&P 500 pay dividends, which is a 17-year high. However, the ratio of capital expenditures is only 6.8%,compared to a historical average of almost 8%. If correct, the industries that should benefit most are commercial construction, especially industrial/warehouse building, real estate investment trusts, railroads, and select tech companies.
Finally, there is an interesting comparison between the U.S. and China. Both nations have been “suffering” from financial repression, i.e., denied a free and open capital market. In the U.S., the capital markets have been largely controlled by the Fed since the global financial crisis in 2008, causing its balance sheet to balloon. With tapering, the Fed has clearly indicated it is lessening its control and will allow interest rates to rise. The U.S. is losing it’s training wheels. Will the economy continue to grow?
In China, there has never been a free and open capital market. However, as part of their ongoing effort to become more consumer-dependent and less export-dependent, they are increasing transparency or honesty in their financial sector. Recently, they even allowed a company to default on its bonds for the first time in China’s recent history. But, a whopping 45% of all debt in China needs to be renewed or repaid in the next twelve months. How much default will the government tolerate? China is also losing it’s training wheels. Will their economy continue to grow?