What happens when the four most dangerous words in the investment language applies to two diametrically opposed viewpoints? Something’s gotta give.

The Wall Street axiom “Don’t fight the Fed” has served investors and traders well for decades. To go against this advisory phrase is to implicitly say “this time is different”.

Valuation history tells that the average P/E ratio for S&P 500 as-reported GAAP earnings is 16 times the trailing twelve months¹. The current trailing twelve months’ P/E ratio is 24 times, which is to say that US stocks are significantly overvalued. To go against this reality is to say “this time is different”.

So, which “this time is different” will win out: the one pertaining to the Fed or the one pertaining to P/E ratios? Logic dictates that both can’t be right. You can’t have the stock market not rise when the Fed is aggressive in its approach toward responding to the every needs of a worried financial market system yet you can’t have a stock market rise very much (if at all on a sustained basis) when valuation levels are elevated. Therefore, to have US stocks rise further from this point requires one of two things to occur: interest rates to go lower or earnings growth to accelerate. Unfortunately, both scenarios are compromised.

Interest rates can only go lower through even more extraordinary central bank actions, including negative interest rates, more cowbell QE, and/or some version of a helicopter drop². And signs of an earnings growth acceleration are forecast to possibly kick in beginning the fourth quarter of this year – maybe³.

To be sure, it is possible that US earnings growth will occur – and even accelerate – as analysts forecast. All one needs to do is look at the earnings projections for mid and small cap issues (see next page, second table to the right) to feel some sense of confidence. If such double digit gains in earnings were to come to pass, US stocks would be more than justified in racing off to new all-time highs. However, what tends to happen with such forecasts is the grinding reduction in the expectations of very rosy times ahead – a tendency that seems built into the mindset and methodologies of nearly all Wall Street analysts. 

Investment Strategy Implications

A large part of the recent stock market rise has been the relief that the US is not on the verge of entering a recession. The chart to your left provides some perspective, although the belief that it takes a 20% decline in US consumer confidence before such a recession could occur seems questionable, as 20% declines in US consumer confidence looks more of coincident indicator than a predictive one.

So, we are back to which “this time is different” will win out? This condition is indicative of the unprecedented nature of a global economy and financial markets that argues for a more conservative view. That being said, it is always worth keeping in mind the John Maynard Keynes famous quote, “Markets can remain irrational longer than you can remain solvent”. To expect stocks to rise at their required double digit rate in these most unprecedented of times on a sustainable basis seems irrational. Then again hasn’t a good chunk of this bull market been exactly that? 

_{1 Since 1936.}

_{2 Whereby the Fed, in conjunction with the Treasury, provides money directly to consumers.}

_{3 See page 4. Caveat: Analyst forecasts, notoriously optimistic, tend to be lowered as time progresses.}