Market Update & Review

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.

P/E 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.

"Despite increasing 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 earnings."

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 80th percentile.

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 wit:

"Valuations are a function of three components:"

1. Price of the index
2. Earnings of the index
3. Psychology

"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 future earnings."

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 costs.

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. However, as 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 growth.

The 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 receive the interest payment stream and the return of the principal investment at maturity. Conversely, with 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 this time."

Unfortunately, it never is.

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