Investors now face a stark dilemma: Should they run toward a brightening global economy? Or run away from the market's towering valuations?
The pessimists' case is simple: Nobody in their right mind sticks around an aging bull market that is pricing stocks at some of the most extravagant levels in history. These things always end badly.
The optimists' response is equally strong: Why leave the party when it's just getting going? The global economy is enjoying its first concerted upswing in years.
Add in the stimulus of U.S. tax reform and we're more likely to see stocks "melt up" than melt down.
Judging from recent gains, such as the record-setting run of the Dow Jones industrial average, the optimists are carrying the day. But it's easy to see why pessimists are so concerned.
Lumbering global giants such as Wal-Mart Stores Inc., Coca-Cola Co. and Boeing Co. are trading at price-to-earnings levels that used to be enjoyed only by rapidly expanding upstarts. Wal-Mart, for instance, changes hands at 27 times earnings, a valuation that would once have been considered typical for a fast-growing software company. Yet, the giant retailer has barely budged its revenue over the past four years, while its earnings per share have actually declined.
The U.S. stock market, as a whole, is fetching more than 33 times its average real earnings of the past decade. By that standard, it is now more expensive than at any time other than the dot-com bubble.
Other markets don't look quite so pricey but are still expensive by historical standards.
In Canada, for instance, stocks were recently trading for more than 22 times the past decade's average profits, an unusually high level, according to Star Capital AG.
Many observers are aghast. GMO, a money manager in Boston, says U.S. stocks are poised to incinerate more than a quarter of their worth over the next seven years. It predicts that stocks of other developed countries will also bleed value.
Even the Federal Reserve Bank of San Francisco, a cautious voice on most economic matters, published a report earlier this month that found "the current price-to-earnings ratio predicts approximately zero growth in real [U.S.] equity prices over the next 10 years."
But – to put this bluntly – so what? Number crunchers have lectured us for years on the priceyness of stocks even as stocks have climbed higher. Investors are used to ignoring warnings.
Right now, they have some good reasons to be optimistic. Gavyn Davies, chairman of Fulcrum Asset Management, says the global economy's long patch of "secular stagnation" – a condition of low growth, low inflation and low interest rates – is giving way to secular expansion.
His company's proprietary readings indicate that 2017 "ended with global activity growing at an annualized rate of about 5 per cent, the strongest rate recorded in the recent growth surge."
This isn't an unusual take. The Citi Global Surprise Index, a gauge that compares how economic data stack up against market expectations, shows that readings over the past six months have come in consistently better than forecasts. This suggests that reality is running ahead of the assumptions built into current stock prices. Small wonder, then, that so many corporate behemoths have benefited.
And growth isn't the only positive. Bulls argue low interest rates more than justify today's elevated valuations. When bonds yield only laughable payoffs, stocks have little competition for investors' affections.
Aswath Damodaran, a professor of finance at New York University, suggests nervous investors should look at the equity risk premium – a measure of how much extra expected return investors are demanding for holding stocks rather than safe government bonds. By his calculation, that premium is "well within the bounds of historical norms," indicating the market is not in a bubble.
To be sure, an unusually aggressive policy of raising rates could shrink the equity risk premium. But Prof. Damodaran points out that U.S. tax reform provides a powerful boost to help offset any drag from rate increases.
By his calculations, the new tax code makes U.S. stocks about 9.7 per cent more valuable than they were before reform. Much of that gain has been built into stock prices in recent months, helping to explain why so many blue-chip U.S. stocks have surged.
Should investors bet on the trend continuing? Alternatives are limited. Unlike during the dot-com bubble, when non-tech stocks were cheap, just about every corner of the current market seems fully priced. Value stocks in emerging markets and gold appear somewhat cheap, but only relatively so.
Rather than seek refuge in bonds, many investors seem willing to bet on their ability to stay in stocks but scamper out before any serious downturn. Like it or not, most of us have become market timers. Expect a wild ride ahead.