Since the beginning of the year, P/E ratios have risen along with interest
rates. Such should be a concern for investors going forward. However, before we
delve into that topic, let’s review the market action from this past week.
As we noted last week,
“The more extreme overbought condition
is about halfway through a corrective cycle, suggesting we could see further
“sloppy” trading next week. With the market holding within a consolidation
range, a breakout to the upside should confirm the start of the seasonal
strong trading period into year-end.”
Such remained the case this past week. Friday was particularly choppy as one of
the most significant options expiration days on record. With nearly $3.2
Trillion in options expiring, stocks traded negatively for the day.
Unsurprisingly, given the recent performance of the mega-cap stocks, which has
recently attracted most of the liquidity flows, the selling pressure was
primarily contained within those names, with value stocks outperforming for the
day. However, the market held support at the 50-DMA on Friday, with the overall
price conditions remaining neutral. Like a groundhog that sees its shadow, the
MACD signal is close to registering a “sell
signal.” If the signal triggers, it could signal a couple of additional
weeks of sloppy trading action heading into October. Such would be consistent
with seasonal weakness before heading into the last trading quarter of the year.
For now, there is no change to the bullish backdrop of the market, and nothing
suggests a need to become more cautious in the near term. It is always possible
that analysis could change over the next couple of weeks, and if it does, we
will suggest reducing equity exposure and becoming more cautious.
With that said, let’s take a look at valuations.
Ratios Are Rising
As we noted last week in “Beware
Of Market Gurus,” analysts are rapidly raising expectations
for both earnings and, by extension, economic growth.
signs of recessionary risk, analysts are once again becoming
increasingly optimistic about earnings growth into 2024. Of course, such
would require substantially stronger economic growth to generate those
Unsurprisingly, market participants follow those earnings estimate increases by
buying companies today, expecting future earnings growth to justify current
valuations. As shown, earnings tend to track the ebb and flow of the market over
time for that reason.
While earnings are starting to tick up in anticipation of more robust economic
growth in 2024, market participants begin bidding up stocks even before earnings
have troughed. Since stock prices rose strongly in 2023, such has led to a
rather sharp surge in P/E ratios, which are well ahead of estimated earnings.
As Goldman Sachs noted recently, valuations across various metrics suggest the
market remains overvalued. With the median absolute metric still in the
historical 94th percentile, such follows a nearly 20% decline in stocks last
year. The most optimistic valuation measure of forward P/E ratios remains in the
The problem, as discussed many times previously, is that P/E ratios have nothing
to do with stock market returns over the next few months or even next year. To
“Valuations are a function of three
Price of the index
Earnings of the index
“The price-to-earnings ratio, or the P/E
ratio, is the most common visual representation of valuations. However, we
tend to forget that ‘psychology’ drives investors to overpay for those
In other words, in the short term, the market reflects investor psychology.
However, over the long term, investor returns reflect starting valuations.
Interest Rates Reduce Valuations (Eventually)
Another problem confronting more bullish investors over the next 12 months is
the rise in interest rates. One of the emerging views is that the “bond
bull market” of the last 40 years is dead, so equities will be the only
place to be. As shown below, the last time the bond-bull market died, in the 60s
and 70s, valuations collapsed along with asset prices.
Furthermore, since 1990, increases in interest rates have regularly aligned with
reversals in P/E ratios, bear markets, recessions, or financial events.
Therefore, the logic should be pretty evident. If interest rates rise, so are
the borrowing costs for corporations and consumers. Subsequently, higher
interest costs reduce consumption and investment, which reduces earnings growth
rates. Therefore, if the current rise in interest rates continues, valuations
must revert to accommodate a slower economic and earnings growth pace. Given the
extremely high debt and leverage ratios in the current economy, it should not
take long before P/E ratios begin to reflect the impact of higher borrowing
Such is particularly the case concerning monetary policy from the Federal
Reserve. Throughout history, each time the Federal Reserve has engaged in a rate
hiking campaign, valuations ultimately reverted. The reason for the reversion in
valuations was that higher rates eventually created either a recession, a
financial event, or both, leading to a bear market in stock prices.
It is currently believed that “this time is
different” because the economic reversion has not occurred as of yet.
discussed recently, the “lag
effect” of monetary policy is delayed due to the massive stimulus and
support programs fostered during the pandemic-driven economic shutdown. However,
as those programs expire and the support programs work through the economic
system, the lag will eventually catch up, exposing economic realities.
Unfortunately, valuation extremes are always reversed by a repricing of
financial assets lower to realign with the impact of higher rates on economic
Inverse Of The P/E Ratio Is A Warning
While valuations have remained elevated over the last several years due to the
massive injections of liquidity from the Government and the Federal Reserve,
combined with near-zero interest rates, the more bullish media turned to the “earnings
yield” to justify overpaying for stocks. However, there are some important
considerations with that justification.
The “earnings yield” is the inverse of
the P/E ratio. While the P/E ratio is calculated by taking the price of the
investment and dividing it by its earnings per share, the earnings yield is just
the earnings divided by the price.
This argument’s basic premise is rooted in the “Fed
Model,” as promoted by Alan Greenspan during his tenure as Federal Reserve
Chairman. The Fed
Model states that when the earnings yield on stocks is higher than the Treasury
yield, you invest in stocks and vice-versa. In other words, disregard
valuations and buy yield.
This is a very faulty analysis for the following reasons. When
you own a U.S. Treasury, you receivethe
interest payment stream and the return of the principal investment at
equity, you DO NOT receive an “earnings
yield,” and there is no promise of repayment in the future.
For example, if I own a Treasury bond with a 1% coupon and a stock with a 2%
earnings yield, if the price of both assets doesn’t move for one year – my
net return on the bond is 1% while the net return on the stock is 0%.
Stocks are all
risk, and U.S. Treasuries are considered a “risk-free” investment.
There is only a slight spread between equities and the risk-free rate. Such
suggests there is little reason to take on significant “equity risk” levels
relative to a risk-free investment.
However, a more appropriate comparison is between the yield on investment-grade
bonds, which is currently higher than the earnings yield on stocks.
Historically, rising bond rates, as noted with valuations above, suggest
problems for investors soon. Previous periods where there was such a sharp spike
in bond yields above the earnings yield were in 2000 and 2008.
Is “this time different,” maybe?
However, the continuing decline in the earnings yield is just another of the
many warning signs discussed lately, suggesting there is still a viable risk to
investors heading into next year.
The problem, as always, with all valuation-related analysis is that it can take
much longer to impact the equity cycle than many think. Therefore, it is often
dismissed under the guise of “it’s different
Unfortunately, it never is.
The views expressed by Lance Roberts are not
necessarily those of RetireEarlyLifestyle.com