1990s
excesses still hanging around
Nearly
everyone searching for insight into the fate of this year’s stock market is
looking back at the Gulf War of more than a dozen years ago. It’s natural to do
so since many of the circumstances are quite similar to the 1991 battle, on the
surface. While an unprecedented economic and stock market boom followed the
Gulf War, don’t expect a repeat of history this time around.
In
political terms, the conflicts are much the same, though the unification of
other nations is more questionable this time around. The focus and location of
the war are the same (as is the name of the U.S. president leading the
attacks); but there is a greater retaliatory threat on domestic turf this
today.
One could
argue that a domestic threat was always there – but that we didn’t know it.
Today, however, this threat is ever present in our minds, particularly for
those of us living near U.S. borders.
Similarities
between 1991 and today are few in economic terms. On the positive side, U.S.
inflation is substantially lower today but not too low. In Canada, inflation is
much the same as it was back then thanks to the sharp war-induced spike in oil
prices and an economy that has been remarkably resilient in this uncertain
time.
Meanwhile,
North American economic growth is moderately stronger today, compared to the
start of 1991. But not all of the figures point to good times ahead.
While
things look good on the surface, looking a bit deeper reveals some mixed
signals. For example, I’ve often mentioned stock price-to-earnings (P/E) ratios
in this column. Recall that the P/E ratio is a reflection of what “the market”
expects in the intermediate term.
The P/E
ratio for U.S. stocks is about 27 today, versus about 15 twelve years ago – and
Canadian data is almost identical. It’s reasonable to conclude that investors
were much more bearish in 1991 as compared to today.
That’s
understandable given the fact that, in 1991, the economy was in the middle of a
very deep recession thanks the highly leveraged boom of the 1980s. It took an
additional year before the booming 1990s really started to show any signs of
strength.
The
confusion comes into play when looking at corporate bond yields, compared to
their government counterparts – i.e. the corporate yield spread. In Canada, the
spread is only marginally higher today, compared to 1991. However, the spread
in the U.S. is at an all-time high.
In 1991,
U.S. corporate bonds yielded about 10.4 percent while government bonds with a
similar term boasted a yield of 7.6 percent – a spread of 2.8 percent. By
contrast, today’s corporate bond yields of about 7 percent are 4.2 percentage
points higher than mid-term government bond yields.
This
historically wide spread means that investors perceive a high level of risk
among bond issuers – i.e. corporate America. In turn, investors push bond
prices down to the point that yields are sufficiently high to compensate for
the perceived risks.
This is
truly at odds with the historically high P/E ratios currently attached to the
stock market. Admittedly, I’ve not gone through an exhaustive analysis of
financial and economic statistics, but this disparity still does not make a
great deal of sense. It may simply be indicative of the variety of opinions
held by market participants today.
(Sources of
this data are the Federal Reserve Board of Governors, Dallas Federal Reserve,
Toronto Stock Exchange, Statistics Canada, and the Bank of Canada.)
The fact is
that there is an abundance of financial and economic data to paint either a
really gloomy scenario or a really optimistic one. However, when you consider
the level of stock valuations along with other macro issues such as debt levels
and stock market prices in relation to economic growth, it becomes clear that
the excesses of the 1990s have some room left before they will be fully
unwound.
While it’s
true that the war will lift some of the uncertainty that currently is
overhanging our economy, a quick victory will not be the instant fix that many
expect, in my opinion.
Avoid big
bets on the timing of an economic recovery and a particular war outcome.
Rather, follow the old adage of true diversification by class of asset while
keeping in mind things like factors
risks.
Dan Hallett, B.Comm., CFP, CFA is the Senior
Investment Analyst with Sterling
Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, Alberta, and Manitoba.