As of this writing the S&P 500 is up over 9% ytd. But since June 27th, the S&P has actually climbed close to 10% and continues to push to new highs. Yellen’s dovish comments this summer have been supportive of this upturn. In the past I have argued that the Greenspan-Bernanke-Yellen “put” had aided the rise in stocks (click here to read), but more recently the Fed, trying to manage expectations and market euphoria, has created a “collar” by releasing more hawkish comments from other Fed governors to keep a lid on market growth (click here to read). The Fed does not want to create a bubble in stocks and at the same time does not want to prick that bubble either. Until recently this doublespeak had kept stocks in a tight trading range; however, the recent spate of hawkish Fed commentary has done little to slow the upward trend in US stocks.
Unfortunately, corporate earnings do not support the advance. We have had four consecutive quarters of earnings declines, yet three consecutive quarters of S&P growth. As a result, the market’s cyclically adjusted P/E ratio, or the price investors are willing to pay for earnings, has risen considerably. While the ratio is not a good indicator of short-term market performance, it is a useful guide to illustrate risk and return.
As stocks become more expensive (higher P/E), the potential downside (risk) increases and the potential upside (return) decreases. This dynamic does not change. Fundamentals eventually matter. Therefore, as P/E ratios climb, risk increases.
And risk has increased. Despite the current ultra-low implied volatility (as measured by VIX), actual S&P volatility (as measured by the standard deviation) has climbed over 50% in the last 12 months.
As I said, the P/E ratio is not a good predictor of market movement, and I am not forecasting a correction, but I think it is important to note the increased risk. Stock prices continue to climb despite earnings declines. While investors can’t eliminate market risk through diversification, they can reduce its negative effect with proper hedging and by varying the risk factors in their portfolios.
Washington Trust Bank believes that the information used in this study was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation for business or a recommendation of the purchase or sale of securities or commodities.
Washington Trust Bank.