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Wall Street fails test of logic as traders bet bubble won't burst


Former Telstra chief executive officer Sol Trujillo is seeking to raise as much as €7.5bn to bid for a stake in Telecom Italia, according to people familiar with the matter.

Former Telstra chief executive officer Sol Trujillo is seeking to raise as much as €7.5bn to bid for a stake in Telecom Italia, according to people familiar with the matter.

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Former Telstra chief executive officer Sol Trujillo is seeking to raise as much as €7.5bn to bid for a stake in Telecom Italia, according to people familiar with the matter.

Wall Street has been on a collision course with logic that has fuelled a stock market bubble. It won't end well.

Take Chinese online giant Alibaba. It racked up the world's biggest IPO, in a move that valued the company at $230bn. After expectations of a share offer of around $80, the float price was discounted to $68 for maximum impact. The shares didn't actually trade for the first two hours because the market couldn't find sellers. Eventually, they took off and closed their first day of trading at $93. Job done!

Alibaba is not some 1990s era dot com puff of smoke. It is a real business that generated earnings of $3.7bn last year. However, the flood of Wall Street investors clambering over each other to invest in it inevitably raises fresh questions about whether stock markets are in a bubble that is about to burst.

At the close of its first day of trading, Alibaba had been valued at over 60 times earnings. Facebook is even worse, trading at 82 times last year's earnings. Either these companies are trading at multiples of their profits that are underpinned by their massive growth trajectories and potential, or they are simply benefiting from a glut of money shying away from poor investment returns elsewhere.

The companies in the S&P 500 index have risen in market value by around $10 trillion since the US Federal Reserve began quantitative easing in 2009.

Stark warnings have appeared consistently over the last nine months in relation to overvalued shares in the US, the UK and elsewhere. If there is a bubble in the US and it bursts, it is very hard to see global stock markets escaping it, regardless of how well investors think their stocks are underpinned by real performance.

American stock markets have been on a bull run since 2009. The economy has recovered from the financial crash but is nowhere near what might be called normal. Between them, the US Federal Reserve, the Bank of England, the ECB and the Bank of Japan have injected over $5 trillion into the financial system in the form of quantitative easing (QE) and other liquidity initiatives.

Incredibly low interest rates have forced investors away from other avenues for their money and towards the stock market. The Dow Jones Industrial Average index of shares has climbed by 72pc since January 2010. The Nasdaq is up 96pc and is just off its record all-time high achieved just before the dot com crash in 2000. The S&P 500 index, which tracks the largest 500 companies listed on the New York Stock Exchange and the Nasdaq, passed the 2,000 mark and is well above its record high, achieved in October 2007.

This in turn may be driven by the fact that some of its biggest companies are technology giants like Apple, whose stock has been sky- rocketing. For example, just three of the index's ten biggest companies (Exxon, General Electric and Microsoft) were in the top ten in 1998. Apple was number 456 while others like Google, had barely been founded.

If the real froth of the S&P 500 is coming from the Nasdaq stocks, that must surely be where the biggest bubble of all is to be found. Tech stock defenders say the Nasdaq is a lot more stable than it was when the dotcom bubble burst in 2000. At the time it had over 4,500 listed companies and now the figure is closer to 2,000, with many of them large, less risky companies.

But Facebook or Twitter might not be risky companies, like start-ups, but the question is whether they are trading at risky prices.

In London, the FTSE 100 index may have doubled in value since 2009 but it is still below its record highs. And in fact, after a solid few years, it is now trading at the same level it was at the start of 2014.

In Ireland the gains have been less spectacular and talking about the ISEQ index is a little less meaningful. The extent of the collapse here was so enormous and the index is dominated by a handful of companies.

However, the index has climbed by 47pc in two years. Put another way, the value of Irish shares is now almost €60bn more than it was just two years ago and €90bn more than in 2009.

Judging whether there is a bubble is more difficult than many professional market commentators would have you think. For example, in an Irish context, there are relatively new companies, like hotel chain Dalata or the REITs, that have yet to show substantial profits, but clearly have strong profit potential.

But those salient facts might not count for much if there is a sharp fall in share prices in the US or in London.

One of the most reliable rules of thumb is to look at the price earnings ratios of companies or entire stock market indices. This is where you take the stock market value of a company and see how many years of earnings that equals. Typically, prospective earnings for the year ahead is used, or sometimes last year's earnings.

On those metrics, FTSE 100 stocks are trading at around 14.1 times earnings. Globally, long term trends points to stock market trading at around 16 times earnings, so it doesn't seem that frothy.

But within the FTSE 100 you have ITV on 26 times, Sports Direct on 21.8 times, SAB Miller on 27 times or Shire on 33 times.

Each of these companies has their own story to tell but when sentiment turns good explanations often don't count for a lot.

Some commentators are refuting a stock market bubble by saying you must take into account the earnings of a company over the previous 10 years, while also taking inflation into account.

Based on that metric, known as the cyclically adjusted price to earnings ratio or CAPE, the FTSE is only on around 13 times.

But that may be a case of examining the trees and missing the wood. Nobody refutes that global stock markets, and the US in particular, have benefited from the fact that huge amounts of money are going into stock markets because of the lack of suitable alternatives.

Deposits will practically cost you money as interest rates remain very low. Bond yields too have fallen dramatically.

But there is another interesting dimension to this. QE is often described as printing money. Actually it isn't. In the old days, governments in trouble printed money and used it to pay for goods and services in the real economy. They would build a new road and pay the builder with newly printed notes. That money went directly into the wider economy. The downside was that as things improved, it led to high inflation.

With QE, the central banks purchase bonds and other assets from banks, which in theory frees up those banks to lend out more money into the economy. When it comes to the stock market, there has been quite a lot of lending going on.

In Ireland we all know how Contracts for Difference (CFDs), which are one form of borrowing to buy shares, did for former billionaire Sean Quinn. Well CFDs, and other forms of what the Americans call margin debt, are back.

US traders have borrowed $460bn from banks and financial institutions to buy shares. Once the cash and other credit balances they have held in accounts is subtracted, there is still a net margin debt of around $180bn. This is compared to around $80bn in 2007 just before the global financial crash and $120bn in 1999 just before the dot com collapse.

Investing in the stock market is always something of a gamble. However, in the US investors are buying up shares at very high prices. This drives values and returns which prompts more investors to pile in.

Borrowed money is being used in many cases, which in itself won't cause a crash, but could mean a burst bubble would be all the more painful.

Traders will argue that the flood of money into equities will continue because the US Fed doesn't want to put up interest rates. The longer they stay low, the longer the bull run will last.

It is as if the market is holding the Fed to ransom, because a sharp stock market fall would be very damaging at this delicate phase in US economic recovery.

If they are right, the run could continue for a little bit longer. But it can't defy logic forever.

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