It has seldom been tougher to make off-farm investments. Markets for stocks have been combed for good values and apparent bargains snapped up. The best index of just how picked over is the S&P 500 CAPE ratio, short for the Cyclically Adjusted Price Earnings ratio. It is at 32 as I write this column, up from about 12 at the bottom of the 2008-09 market meltdown
The CAPE index smooths out the wobbles in average price of the biggest 500 companies in the U.S. Getting rid of some short-term noise adds clarity, but the underlying issue is that stocks are very expensive and getting more so.
Today, the S&P 500 index is 47 per cent over its February 2016 low. It has risen dramatically even though the great leveler of the stock market, interest paid on government bonds, has risen dramatically. As of early January, the 10-year Government of Canada bond yielded 2.20 per cent per year, more than double the prevailing rate just six months ago. U.S. Treasury 10-year bonds yield 2.54 per cent, also double rates earlier in 2017.
Bond interest is hugely influential for share prices because it sets the cost of borrowing money to buy stocks. So far, government bond interest rates, though rising, are low on an historical scale.
Why are stocks rising?
Why are stocks are thriving in spite of warnings signs from the bond market? Top candidate: there is so much money sloshing around as a result of the massive bond purchases by central banks used to reflate banks’ after 2009 and, of late, extensive stock buyback moves by big issuers like Apple Inc., that old-fashioned measures like price/earnings ratios are being disregarded in favour of momentum investing. That means people are not buying companies so much as they are betting on the trend. It’s very dangerous kind of speculation.
So if you like pot stocks at 1,500 times estimated 2020 earnings, goes the logic, you should like them even more at 3,000 times estimated earnings. This is flawed logic, for it should be the other way round. But this is a market for the very nimble and the gullible.
If this concept, that suckers rule, needs validation, consider the fortunes of such pot stocks as Canopy Growth Corp, symbol WEED on the TSX. It was selling for $8.40 per share on July 24 and, as I write this, it is trading at $41.17, which is about a 500 per cent lift in five months. WEED has no earnings, no dividends, its legal status is not quite settled, there are many competitors and devotees can grow their own. Recreational marijuana may replace tobacco and even booze, for all I know, but the word is “may” and I would not throw good money into this abyss.
The cryptocurrency craze
Even more outrageous are Bitcoin prices, which have been going for something like $17,000 dollars each, up from about zero a few years ago. Bitcoin is a synthetic commodity enthusiasts generate via a qualification process on their own high-powered computers. The quantity of Bitcoin in circulation is limited, but there are numerous competitors in the digital currency biz.
Bitcoin is scarce and transactions are untraceable. But if you want to convert Bitcoin to real currency, there are paperwork costs and exchange fees of several percent. Competing with scarce Bitcoin are 800 — that’s eight hundred — other digital currencies such as Ethereum, Ripple and Litecoin. Kodak recently announced it would go into the digital currency business too. As of early January, the value of Bitcoin outstanding was reportedly US$284 billion with another US$122 billion in competing cryptocurrencies.
Friends, in spite of the cryptocurrency frenzy, it will not last. Four hundred years ago in the Netherlands, tulip mania convinced sober people to sell their houses and borrow against all their worldly assets to buy tulip bulbs. In 1637 one speculator offered five acres of land for a Semper Augustus bulb. The market crashed shortly thereafter when folks realized that tulips make more of themselves and that they would not long be scarce. Ditto Bitcoin, except that digital money is not as pretty as a flower. Moreover, with values of coins zooming and plunging by 20 per cent on some days, your odds of winning or even your ability to stick out the volatility are probably not as good as in Russian roulette where, with a six gun and one bullet in the chamber, you have a five-out-of-six chance of walking away unharmed.
A look at the basics
Let’s assume digital currencies crash in flames due to oversupply and the fundamental fact that they are synthetic money backed by nothing more than electricity. Let’s therefore look at basics:
- Government bond prices will soften as long as interest rates rise. Rise they will, due to central bank moves and because the Trump budget creates huge deficits that have to be financed by Treasury bond sales. To get more money, the Treasury cuts prices and yields (interest rates dividend by prices) inevitably rise.
- Corporate bond yield will rise even more. Top quality corporate bond prices will fall even more. Junk bond prices will fall from their recent highs. Bonds are a pit for now.
- Stocks with solid dividends that tend to rise over time can do very well in this rising interest rates environment, even banks with a lot of debt that has to be financed with more bond borrowing. Banks make more money when interest rates rise, as the spread between what they pay on savings and lending rates widens.
- Real estate prices will be under pressure, for almost everybody borrows to buy property.
There are few enduring truths in stocks and bonds beyond the guarantee that prices bob up and down. However, if you buy solid value — strong companies with growing income and rising dividends, valuable products and well-defined markets — things should work out in the long run. Invest, diversify and let the bandwagon of foolishness rumble on with you not aboard.