Gloomy days ahead?

Nothing Grows Forever, Including the Stock Market

A. Gary Shilling is president of A. Gary Shilling & Co., a New Jersey consultancy, and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” Some portfolios he manages invest in currencies and commodities.
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Major stock indexes may be at or near all-time highs, yet I see a number of warning flags for equities. Yesterday, I examined four of them: high price-to-earnings ratios, slow economic and corporate-revenue growth, earnings growth driven by unsustainable cost-cutting and low interest expense, and the end of Federal Reserve stimulus. In today’s column, I examine five more caution signs.

Emerging market woes. Economic growth in China is slowing. Its banking and other domestic problems could spill into other countries. Furthermore, many developing economies are already troubled, especially the poorly managed ones with current-account deficits, weak currencies, high inflation, falling stock markets and rising interest rates.

Less rapid growth in China creates problems for the many other developing countries that export commodities and other products to China, especially Indonesia, South Africa, Brazil and Turkey, all of which suffer from current account and government deficits, high inflation and weak currencies. The robust greenback is straining emerging economies with sizable debts denominated in dollars.

Currency losses. Currency translation losses for U.S.-based companies are already evident in emerging markets with faltering currencies. When converted into fewer and fewer dollars, earnings from exports to those countries and revenue from operations there look a lot smaller. With slow global growth and the universal rush to the safe haven of the U.S. currency, prospective deflation is spreading to commodity currencies such as the Canadian, Australian and New Zealand dollars.

Meanwhile, to stave off deflation and promote economic growth through exports, Shinzo Abe's government in Japan is doing its best to junk the yen and the European Central Bank is determined to trash the euro.

Heavy stock buybacks. Stock buybacks are often a sign of a peaking stock market as corporate managements follow the usual pattern of buying high and selling low. At the end of 2007, as stocks were beginning to swoon, buyback activity was near record levels but disappeared when stocks cratered. More recently, in the first half of this year, corporations bought back $338 billion of stock, the most for any six-month period since 2007. Through August, 740 companieshave authorized repurchase programs, the most since 2008. In contrast, at the depth of the bear market in the fourth quarter of 2008 and the first quarter of 2009, buybacks only totaled $97 billion.

Bear in mind, buyback announcements are not the same as actual purchases. Corporations may enjoy a stock boost because investors anticipate fewer shares outstanding and therefore more earnings per share, yet some companies don't intend to carry through.

Of course, a buyback this year contains no promise for a repeat next year, giving management more flexibility. In contrast, investors generally expect dividend increases to persist. Also, except for reducing the shares outstanding, buybacks reward departing shareholders who sell their stock, not loyal equity owners who stay. There’s also the question of whether management could have used the buyback money to invest in productive activities. Nonfinancial corporations on average have more cash relative to their total assets than since the 1950s -- and they’re still holding back on investments.

Lower dividends. Dividend yields remain low, as do payout ratios on average. Of course, one can argue that sizable dividend yields aren’t needed to attract investors in today’s low interest-rate climate. Still, there’s nothing like the cushion of dividends to soften weak stock markets. One example: Utilities, which pay handsome dividends, have risen more than 12 percent this year, outperforming major indices through mid-September.

Speculative buying. Young, unproven companies are issuing stock in the busiest year for initial public offerings since 2000. On Sept. 19, investors charged into Alibaba Group Holding Ltd.'s IPO -- the biggest ever -- and pushed the offering price up 38 percent on the first day of trading. Could it mean a stock-market top?

Speculation hasn't returned to the levels of the late 1990s' dot-com nonsense, but it certainly has been high. Small investors have been rushing back into stocks, which often is the case at market peaks. And in this era of low-interest returns and investor zeal for yield, equity investors are pursuing growth stocks of all stripes.

Normally sedate fixed-income buyers are also chasing new corporate bond issues. Another sign of pursuing returns regardless of risk: Junk bond issues have been especially numerous.

Of course, nothing goes up forever, including high-flying stocks. From the beginning of 2013, social-media stocks jumped 78 percent to their March 6 peak, then fell by more than a quarter through early May. The Russell 2000 index of smaller companies has been choppy this year.

Despite these nine warnings flags for the equity market, there is no clear sign that U.S. stocks are about to nose dive -- unless the economy falters or another shock unfolds. Late in an economic expansion the Fed normally worries about overheating and inflation rising. So it tightens credit and pushes up short-term interest rates until they exceed long rates. The resulting inverted yield curve has been a sure sign of an impending recession in the post-World War II era.

Now, however, the yield curve is distinctly positive and the Fed says it won’t begin raising short-term rates until well into next year, and possibly later if slow growth persists. For now, the Fed is more concerned with deflation than inflation, as is the European Central Bank.

It looks like stocks may continue to rise in a risk-on climate until a major shock, such as excessive speculation, a blowup in the Middle East or a financial crisis in China, forces investors into anagonizingreappraisal.

This is the second article in a two-part series.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
A Gary Shilling at insight@agaryshilling.com

To contact the editor on this story:
Paula Dwyer at pdwyer11@bloomberg.net