Despite US Federal Reserve chairwomen Janet Yellen’s relative comfort with US stock valuations, there are some concerns regarding Wall Street still lurking below the surface.
In testimony before the US Senate this week, Yellen argued that
“while prices of real estate, equities, and corporate bonds have risen appreciably and valuation metrics have increased, they remain generally in line with historical norms.”
If we focus on the all important equity market, such a statement seems reasonable at face value. After all, as at mid-July, the S&P 500 price to 12-month forward earnings ratio is around 15.6, which is only slightly above its average since the late 1980s of 15.4.
Relative to US 10-year government bonds yields, moreover, US equity valuations still appear on the cheap side, with the differential between the market’s forward earnings yield (inverse of the forward PE ratio) and 10-year government bond yields at 3.8%, or well above the average since the late 1980s of 1.6%.
So far so good, but here’s where it gets complicated. For starters, part of recent history includes a notable period of internet-related bubble conditions from the late 1990s to early 2000s. In the six years to mid-2002, for example, the PE ratio averaged an uncomfortably high 20.2 times forward earnings. Excluding this period, the forward PE ratio averaged only 13.8, suggesting current valuation levels of almost 16 may be getting uncomfortably high.
What’s more, valuations relative to interest rates are being supported by unusually low bond yields. At 2.5%, 10-year government bond yields are about half their average level since the late 1980s. Yields are also still well below their decade average of 3.4%.
The other lingering concern with the US equity market is the sustainability of corporate profits. Again, price-to-earnings valuations have also been supported by an unusually strong upward trend in the US corporate profit share over the past 15 years. Having averaged around 6% of GDP over the past 50 years, the national accounts measure of profits after tax has since lifted strongly, to be now at a record high of 11.2%. Other earnings measures – such as reported earnings and forward earnings – have also trended up in the past decade or so.
Even if the US profit share has lifted to a new average level – perhaps associated with the benefits of globalisation and the IT revolution – they can’t keep rising relative to GDP forever, suggesting some slowdown is in prospect. And if the profit share is unsustainably high, the downside to US profits is even greater.
That said, with the US economy enjoying a cyclical recovery, it’s hard to see US profits collapsing anytime soon. And given still considerable US labour market slack (partly disguised by low workforce participation), the Fed seems likely to keep interest rates low for at least another year. In a sense, America is enjoying the cyclical “sweet spot” where growth is improving, but enough lingering slack remains to keep inflation and interest rates relatively low.
This is providing a good backdrop for Wall Street, with prices pushing on to new highs. But it’s hard to escape the feeling America is setting itself up for a harsher market adjustment once the inevitable lift in interest rates to more normal levels begins in earnest.