The equities bubble is 'totally inconsistent' with weak economic fundamentals, writes PROINSIAS O'MAHONY

THE HUGE run-up in global markets over the last seven months means that meagre returns await long-term investors and a “painful” correction is growing ever more likely, a number of big names in the financial world warned this week.

Valuation concerns have seen the MSCI World Index fall for seven straight days, its longest losing streak since January. In his much-awaited quarterly letter to investors, value investing legend Jeremy Grantham cautioned that US equities were now overvalued by almost 25 per cent.

Grantham had famously described the global financial system as a “slow-motion train wreck” in 2007. He reversed course as the market bottomed in March, when he recommended investors pile into stocks even if “terrified”. He said fiscal stimulus and historically low interest rates had “overstimulated the risk-taking environment” to the benefit of “junky, weak, marginal companies and zombie banks”, a “hair-of-the-dog strategy if ever there was one”.

Even though Grantham had earlier this year predicted that market momentum would likely carry indices to their current highs, he said that it was “odd” that markets were “apparently quite unrepentant of recent crimes and willing to be silly once again”. Momentum and “herding” might carry the market higher still, but stocks would “drop painfully” in 2010, likely falling “below fair value” in the process.

Corporate profit margins remain above historical norms, Grantham said, and the coming lean economic years would see companies “look back nostalgically” at these profits.

Grantham is not the only commentator to warn that this is a liquidity-driven rally. George Soros told the Financial Times that markets had rallied because “an awful lot of money is on the sidelines and it earns no money at all, and gradually it’s being sucked into the market”. This process would “probably” continue into year’s end, although Soros said he “can’t see” hopes for a v-shaped economic recovery being fulfilled.

Influential economist Nouriel Roubini, meanwhile, said that a “wall of liquidity” was chasing equities and commodities. What is being termed the dollar carry trade, whereby investors borrow dollars at ultra-low interest rates and invest in higher-yielding assets around the world, was creating an asset bubble that was “totally inconsistent” with weak economic fundamentals, he said. Any reversal of dollar weakness could see investors dump assets, Roubini added.

Like Grantham, British investment guru Andrew Smithers is also troubled by current valuations. Smithers said that there are only two “valid” ways of valuing markets – one either uses a cyclically adjusted price/earnings (P/E) ratio (see panel below) or the so-called Q ratio, which compares companies’ market capitalisation with their net worth, adjusted to current prices.

“Whichever technique is used, the answer is the same,” Smithers said. “The US stock market is overvalued by around 40 per cent.”

Completing this week’s chorus of equity warnings was the world’s biggest bond manager, Pimco’s Bill Gross, who cautioned that the furious rally in risky assets was “likely at its pinnacle”.

Over the past 30 years, Gross wrote in his latest monthly market monitor, equity and property prices had risen twice as fast as they should have based on economic fundamentals. As asset prices rose, “consumers liquefied and spent the capital gains”. Now, “almost all assets appear to be overvalued on a long-term basis”, Gross said, and the downside to an asset-backed economy meant a “new normal” of lower economic growth in coming years. Investors had been “beguiled” by hopes of a v-shaped recovery, he warned.

The SP 500’s 60 per cent advance between March and mid-October has made it the fastest rally in history. Increasingly bullish analysts project that average company earnings will increase by 53 per cent over the next two years.

Investors, however, appear to be getting fussier, given that the recent falls come in the face of a strong start to the US earnings season.

The irony, Grantham warned, is that, just as weak economic data in 2009 has been accompanied by a rip-roaring market, “strong economic data next year is likely to be accompanied by a weak stock market”.