The S&P 500, by far the world’s most tracked stock index, is almost back to its all-time high, write John Authers and Gillian Tett in Wednesday’s FT. Earlier this week it traded above its highest closing level at the top of the tech bubble in March 2000, after a four-year rally.
The landmark is of genuine importance. It has been achieved on the back of a dramatic expansion in US corporate profits, which still continues, and comes as defaults are running at a record low.
In Europe, too, stock markets are trading at, or close to, levels not seen since the start of the decade, while emerging markets – notably China and several Latin American countries – are setting records day by day. And yet, nerves are widespread that a correction is in the offing.
So what are the main reasons for concern? Fund manager Anthony Bolton’s recent unease centres around the credit market. Since the S&P was last at a high, new derivative instruments have transformed lending. Banks are no longer the only players on the hook when loans turn bad. That is partly because they are increasingly selling loans to other investors such as hedge funds, and also because there has been an explosion in the use of credit derivatives – which provide a form of insurance against the risk of credit default.
This makes banks less vulnerable to individual defaults. But it could also be making them feel so comfortable about lending risks that they are making more risky loans. Outside investors such as hedge funds are gobbling them up, either because they also think they are protected with credit derivatives or because they are desperate to find somewhere to place their cash.
This has triggered a collapse in the standards used to conduct and fund deals. In recent months, most of the legal covenants that once protected lenders have been stripped away from many deals. The net result is that private equity funds can raise money with fewer strings attached – at the same price, or even cheaper, than before. That lets them launch increasingly aggressive bids.
Tobias Levkovich, US equity strategist at Citigroup, points out that the buoyant credit market creates an “incredibly attractive” logic for buying shares. In the US, he says, the high yield that risky companies pay to raise money using “junk” bonds is more than 2 percentage points lower than the equivalent yield produced by companies’ cash flows. So a private equity buyer can take over a company and comfortably cover the cost of borrowing without doing anything to improve the company’s profitability. This is pure financial arbitrage.
However, the classic macro-economic conditions for a market break do not appear to be in place. The US economy is still growing, albeit relatively slowly. Other economies are growing faster, and multinational companies are using globalisation to reduce costs and lift profits.
Moreover, by the most popular measures equities do not look expensive. The S&P 500 is trading at a multiple of 18 times historic profits, the same as a year ago. In 2002, the S&P traded at a multiple of 46. Equity valuations are also being boosted by companies themselves. They are buying back their own stock at a record rate, which makes equities more valuable since there are less available to buy, and also paying big dividends. This so-called “de-equitisation” trend is notable in the US, but most dramatic for London, where the stock market shrank by 4 per cent last year, according to Citigroup.
The level of market volatility is also low. The Chicago Board Options Exchange’s Vix index, based on the price investors pay to insure against volatility using options on the S&P, currently stands at 12.8. That is up somewhat from the all-time low of about 10 earlier this year but far below its 10-year average of just over 20. The Vix reached 45 in 1998, at the peak of concern over the meltdown of LTCM, the hedge fund.
Volatility normally increases more than this before a crash. In the three years before the S&P peaked in 2000, the market suffered six “corrections” when it sold off by more than 9 per cent and then recovered. There has been no such significant correction in the four years of the S&P’s current advance.
The credit markets could reverse if defaults increase. But this seems unlikely in the very near term. There is another factor to watch: the behaviour of retail investors. Last time around it was the wall of optimistic money from US retail investors that fuelled the market’s advance. But this time the US small investor has remained on the sidelines during the S&P’s entire four-year rally. In the 12 months to the end of March they actually removed a net $500m from US equity mutual funds, according to the Investment Company Institute. Meanwhile, they put $131bn into foreign equity funds and $65bn into bonds.
So before the stock market suffers a tumble, we will probably need to see a last sharp rally provoked by the entrance of retail investors, an increase in volatility, the bursting of asset price bubbles and, most importantly, a credit market downturn. A major geopolitical event, such as a terrorist outrage to compare with 9/11, might have a similar effect. So might some smaller tremor that triggers a sell-off in credit markets.