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Are the markets nearing a top?

With the S&P cruising past 1,500, is it time to start trimming your long positions? Not necessarily

When he was younger, Max Fawcett wanted to make a mint in the markets. Now as the managing editor of Alberta Venture he gets to write about them. Close enough, right? He can be reached at

Jan 25, 2013

by Max Fawcett

With central banks around the world pumping liquidity into the economy and stock markets back near all-time highs, it’s tempting to think that we’re watching yet another asset bubble getting inflated. As the Washington Post’s Ezra Klein pointed out on Wednesday, the last time the S&P 500 posted a four year gain as strong as the current one was from late 1996 to late 2000, which was, as he put it, “a time of an epic bubble.” If the U.S. Federal Reserve takes its foot of the QE gas, as some of its members hinted they might like to during its last meeting, it’s tempting to think we could see all of the gains of the last two years evaporate in yet another stomach churning crash.

Don’t bet on it, Klein says. The difference between 2013 and 2000, he says, is that companies around the world have spent the last four years paying off debt, deleveraging their balance sheets and laying off redundant employees. They have, in other words, become better at what they do. “Tabulations by Bloomberg News based on 11,000 analyst estimates,” Klein wrote, “found that 2013 earnings for the Standard & Poor’s 500 are expected to be about $1 trillion, 31 percent more than the 2007 peak. If you’re an investor buying into the stock market, you are getting much more earnings power out of Corporate America at a lower price.”

Generally speaking, when the equity markets’ earnings yield exceeds the 10-year bond yield, it’s probably a good investment. As it stands today, the earnings yield (that is, the earnings-to-price ratio) is approximately 6.7 per cent. And where are 10-year bond yields right now? Under two per cent. “The gap between those two numbers, nearly 5 percentage points, is, in effect, the extra compensation investors receive for investing in risky stocks instead of safe bonds,” Klein wrote. “Even before accounting for the fact that corporate earnings rise over time while bond coupons are unchanged, that is a remarkable premium – and one that suggests that stock investors are being well compensated for the risk they are taking on.”

Compare that to 2000, Klein says, and it becomes even clearer that not all stock market highs are created equal. “At the peak of that boom, the S&P had an unprecedented price to earnings ratio of 31.4, which translates into a 3.2 percent earnings yield. At the time, Treasuries were yielding 6 percent. In other words, investors were so insanely confident that corporate earnings would skyrocket in the future that they were willing to accept a nearly 3 percent lower yield than they could gain from ultra-safe bonds. Instead of being compensated for taking extra risk by investing in the stock market, investors were sacrificing 3 percentage points of yield in exchange for joining the great Internet hype machine.”




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