As unpredictable fingers hover nuclear buttons, markets are too sanguine

The so-called Shiller PE ratio is based on average inflation adjusted US earnings from the previous 10 years on the S&P500.

Otherwise known as the cyclically adjusted PE ratio or CAPE, it was never intended to be an indicator of looming market crashes, and it has not always indicated tops or bottoms in the market. The CAPE has also been criticised for failing to take into account changes in the way earnings are calculated. This is important because a higher than average CAPE implies lower than average annual returns, and so a high value now may not be the risk it might otherwise be. But despite all these caveats, I’m worried because of geopolitical risk.

The latest value for the CAPE is around 30, the same as on Black Tuesday in 1929. The CAPE has only ever been higher during the dotcom boom of the late 1990s when it reached 44.2 in December 1999, before falling back into the mid twenties. Over the past century the CAPE has averaged 16.8, so it’s almost double the long-term average.

My concern is that a CAPE at this level can only be justified by strong economic and geopolitical expectations, and that at the moment at most we only have the former, not the latter. So leaving aside the debate about US economic prospects (which may also question current valuations), geopolitical risk centered on the 38th parallel alone, doesn’t justify levels.

An obvious counter argument to this is that the current wrangle over North Korea is all bluster, and that it suits both Kim Jong-un and Donald Trump. In other words it won’t develop further, at least in the short-term. But even if the current rhetoric calms – which it probably will – North Korean attempts to build a weaponised ICBM will almost certainly continue, and the countdown to a big bomb sitting on top of a big rocket is underway. Then what? Just ignore it? By then it will be too late. Economic sanctions and Chinese pressure all appear to have failed. The only option remaining on the table is increasingly military, and there isn’t really a military option either. That would spook financial markets even if the greatest of statesman occupied the Oval Office.

But it hasn’t.

Ever since the President was elected, financial markets have absorbed good news (potential tax cuts, deregulation, infrastructure spending etc.) and ignored bad news (potential protectionism, impeachment etc.). Financial markets have now merely extended this mode of thinking from the political to the geopolitical.

In fairness to the President the North Korean problem was not of his making, it would have faced Hillary Clinton also, had she been elected.

But it has landed on the 45th President’s watch and he now has to deal with it. We’ve seen rhetorical fire and fury over recent weeks, but this is a geopolitical challenge to dwarf Isis, Syria, Iraq and Afghanistan. Tweets won’t solve the problem, but it is not at all clear what will either. The risk of a nuclear escalation is not insignificant, and the mere fact that a nuclear exchange could even be contemplated is surely a signal that financial markets are far too sanguine at present.

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