Calm before the storm? 4 reasons global stock markets could crash

Global stock markets may have hit a record high, but earnings aren't rising as fast as share prices.

by Rachel Savage
Last Updated: 13 Oct 2014

Equities are the gift that keep on giving at the moment. The Dow Jones Industrial Average hit the magic psychological barrier of 17,000 for the first time ever yesterday, after the US economy added more jobs than expected. Asian markets hit a three-year high today and the MCSI All World share index scored a record peak too.

While the rash of good data keeps coming (apart from in the dragging Eurozone), share prices in general are going to keep on rising. There are some good reasons, though, to be suspicious about whether the bull that has been running since the last crash in 2008 still has fuel in the tank.

1.  Earnings are not rising as fast as share prices

Share prices should move roughly in line with expected profits – if a company is making more money and looks like it will keep on doing so, then it’s probably worth more. But as fund manager Sebastian Lyon pointed out earlier this week, company valuations, as measured by the share price-earnings ratio, have gone up 35% since the start of 2012 in the US and 39% in the UK.

Meanwhile, he adds, earnings haven’t matched that growth and aren’t likely to catch up with it. Earnings forecasts for the next year in the UK and Europe have been downgraded 12.5%, the third consecutive year estimates have been cut, stockbroker Charles Stanley told the Telegraph.

All other things being equal, then, share prices should really fall to bring valuations down to more sensible levels.

2.  Companies are buying back shares like there’s no tomorrow

In the first quarter of this year, American companies spent $160bn (£93.3bn) buying back their shares, according to data from S&P Capital IQ. That’s the highest level since before the financial crash in 2007.

The buybacks are driven, at least in part, by reluctant-to-invest businesses that want to put their spare cash to use somewhere. They also inflate earnings-per-share (EPS) ratios, by decreasing the denominator (the number of shares). Conveniently for executives, remuneration is often tied to the EPS. Share prices can be too, which means companies may be overvalued if their EPS is being artificially pumped up.

3.  The era of cheap money can’t last forever

A lot of companies have been making hay while the cheap money flows. As well as quantitative easing pumping cash into the economy, interest rates have been historically low for, like, ever, so why not take out loans and issue bonds?

That kind of attitude means corporate net debt is now above 2008 levels, according to Société Générale. Meanwhile, the Fed has been gradually scaling back asset purchases (although the ECB has just turned on the cash taps to try and get inflation heading up again).

Central bankers have also been harping on about how interest rate rises will be gradual when they do eventually happen. Apart from not wanting to spook the markets, they know they can’t just pull out the rug from underneath debt-laden companies. Still, businesses’ heavy debt burdens are a risk – and not just to their share prices.

4.  The markets are getting complacent

Everything is eerily calm in the financial markets at the moment. The Vix, an index that measures the S&P 500’s volatility, keeps on falling and is now at 10.32, a level not seen since 2007. When the financial crisis kicked off it swung up to 80.

This could be the calm before the storm. As economist Hyman Minsky observed investors get complacent in the quiet times, taking on too much risk and blowing up asset bubbles that eventually burst.

Stability is good for growth though. If companies and consumers feel more certain about tomorrow they’ll be more likely to invest and less likely to horde cash. Low volatility and economic good times thus go hand in hand in a virtuous ring-a-roses.

Until, that is, the financial markets get ahead of themselves and end up crashing the party. If they send stock markets and the global economy over the edge again while everything is still in recovery mode, then today’s banker-bashing could look like a playfight compared to the baying for blood that would inevitably ensue.

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