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Risk is building up

The term ‘sweet spot’ is becoming commonplace in the current market – even Fed members are using the term, with San Francisco President John Williams using it continuously in an address on Monday.

US market
Source: Bloomberg

‘Sweet spot’, to me, means risk is building in asset classes such as bonds and equities.

The term suggests that everyone should be getting involved with the ‘trade of year’ - which is what is happening - and more and more funds are piling in to equities across the globe.

As investment risk appetite balloons due to this so-called ‘sweet spot’, how high can markets move as central banks continue to push the accommodative button?

Will the bloated equity markets find a random event and violently react to the underlying issues or will they just power ahead as investors ignore the underlying fundamentals because of a yield 200 basis points or more above the domestic cash rate?

The momentum is clearly telling me the next move is still to the upside. We never like to go against the trend as the market will always prove you wrong well before you prove it wrong.

However, a cause for concern and the reason why I see risk in the markets becoming a real issue is the fact price to earnings ratios (P/E) are starting to have double-digit two handles, making them well and truly above historical averages.

P/E ratios are not a perfect way to price a security or indices but P/Es do give the best indication of whether earnings are justifying the price levels. I see the risk build-up in the market as a bottom-up issue – the actuals are not meeting expectations.

Earnings are sluggish, companies are consolidating and cutting costs rather than using the current bottom of the cycle to buy up depressed assets for future growth. For the past three years, the EPS growth seen has been down to consolidation rather than business growth whether you look to China, Europe or even the US where things are improving.

Here are the current P/E ratios for a few major indices around the world:

The S&P is trading on a P/E of 18.63 times

The FTSE: 24.04 time earnings

The DAX: 20.07 times earnings

The Nikkei: 22.36 time earnings

The ASX 200: 21.11 time earnings

(Source Bloomberg)  

Although forward P/E ratios for the above indices are lower, they are all higher than historical levels and are premised on the idea earnings will improve significantly – there are risks to these assumptions too.

How will it end?

I see two major risks to the current scenario:

The first is the slow burn of capital erosion. The drive into yield at the expense of total return and capital growth could see a very subtle hit to the market.

The second is what happens when the ‘sweet spot’ evaporates? The Fed got an upside surprise in new housing overnight – is that a further sign the US is at full employment? Could they move earlier than expected? However slight the move in the Fed funds rate is, it will cause investors to challenge the reasoning for the lofty P/Es and cause the hot money to look for the exit.  

Ahead of the Australian open

We are calling the market higher by 10 points to 5979, a suggestion the 6000 level will be tested again. The drive will likely come from more hot money piling into the yield trade as the interbank market crossed over 100% chance of a May rate cut on the back of the Chinese manufacturing data. It settled at 98.7%, having risen to 100.75%. The risk here is clear – what happens if Glenn Stevens holds off again?

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