BETTING ON BEN / THE ECONOMIST BUTTONWOOD COLUMN ( VERY HIGHLY RECOMMENDED READING )

Buttonwood

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Betting on Ben

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Central banks have been supporting share prices

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Feb 17th 2011 | from PRINT EDITION

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LET all equity investors give thanks to Ben Bernanke. Global stockmarkets were struggling in the first half of 2010 but began a remarkable rally in August once the chairman of the Federal Reserve signalled that the central bank would launch another round of quantitative easing.

Higher share prices are part of the Fed’s plan. Back in November Mr Bernanke wrote in the Washington Post that “higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

This is an overt version of the “Greenspan put”—the idea, named after Mr Bernanke’s predecessor, that a central bank stands as an insurer of the equity market. If the Fed is aiming to boost equity prices so that consumer confidence is bolstered, it logically follows that the bank is happy for share prices to be above their natural level. After all, without central-bank action, share prices would be lower.

One guide to the artificial level of share prices in America is the cyclically adjusted price-earnings (p/e) ratio, which is calculated by Robert Shiller of Yale University. This measure averages earnings over ten years to smooth out the peaks and troughs of the economic cycle. At 23.7, the current ratio is about 45% above its historic average and close to the level of two of the 20th century’s four big peaks, in 1901 and 1966.

In the past, subsequent real stockmarket returns have been low when the Shiller p/e ratio has been this high. But in the short term corporate profits have been so strong that investors are inclined to dismiss the Shiller measure, just as they did during the late 1990s.

This column has repeatedly argued that the stockmarket rally has had an ambiguity at its heart. Record-low interest rates have cut borrowing costs for homeowners and businesses, bolstered the profits of the banking sector and tempted investors out of the safety of cash. But those low interest rates are a sign that central banks are still very worried about the fragility of the economy: in its 300-year history the Bank of England has never kept rates so low.

There would seem to be a disconnect between the buoyancy of stockmarkets (which ought to reflect a positive economic outlook) and the caution of central banks. The recovery is not as strong as it might be in the developed world. Britain, Japan and Portugal all suffered GDP declines in the fourth quarter of 2010. Higher commodity prices also pose central banks a dilemma, pushing up headline inflation rates while also acting as a tax on consumer demand.

As if these macroeconomic worries were not enough, share prices also face a potential hurdle in the form of deteriorating demography. In its latest “Equity Gilt Study”, Barclays Capital tested the outlook for the American equity market against a number of population variables.

It found that the most important relationship is the ratio of “low savers” to “high savers”. The first category comprises those in the 25-34-year-old age group, who are borrowing to buy houses, and those in the 65-plus group, who are running down their savings to finance their retirement. The second category comprises those in the 35-54 age range, the prime earning and saving years.

The ratio between the two was pretty flat for the first half of the 20th century, and then soared in the 1960s and 1970s, as the baby boomers left college (see chart). It peaked in the early 1980s, just as shares were reaching the end of a long bear market.

The ratio fell sharply as the baby boomers reached their prime saving years, hitting a low in 2000 at the time of dotcom mania. It is now climbing inexorably again as the boomers retire.

With fewer savers to channel money into the stockmarket, the model suggests that equity returns will be just 3% a year in real terms, or 5% in nominal terms. Even that figure may be too high. It is based on the consensus forecast for American GDP growth of 3% a year. But given that debt crises tend to be followed by sluggish recoveries, GDP growth may be lower. Drop the growth forecast to 2% and the Barclays model suggests nominal equity returns of less than 4%.

These kinds of model cannot forecast the short term, however. And in the short term it is hard to see the rally being halted unless central banks are forced to raise rates or there are signs of faltering growth in America or China. When you buy equities, you are betting on Ben.