In this week’s Market Shadows Newsletter: Lights, Camera, Rally?, Paul Price explores Price/Earnings (P/E) ratios and finds the S&P 500 trading at average levels. This, however, is not the end of the story. P/Es do not exist in a vacuum.
Equities compete with bonds, CDs, real estate, and all other asset classes for investors’ money. To know where P/Es should be, theoretically, we need to compare P/Es to interest rates. Higher available coupon rates dictate lower expected market P/Es. This makes sense. For example, in the early 1980s, you could buy fully-insured bank CDs paying 10% -15%. 30-year treasury bonds locked in non-callable 13.5% coupons. When such “risk-free” assets are yielding such high returns, the price of equities falls. The price of equities factors in their higher risk in comparison to the low-risk assets paying high returns. So equities become less desirable. I.e., holding E (earnings) the same, decreasing equity prices, due to increased relative risk, translates into falling P/E ratios…
With the backdrop of very low interest rates, the overall ‘should-be’ P/E of the stock market increases because the alternative “safe” investments are paying such low yields. Stocks become more desirable. This dynamic makes higher risk assets, such stocks, look even more attractive. And that’s exactly what the Federal Reserve wants.
The Fed is artificially holding interest rates down with its successive quantitative easing programs (QE1, QE2, QE3, QEternity….) and its Zero Interest Rate Policy (ZIRP). Part of Ben Bernanke’s plan (or plot, some might say) is to compel investors to buy “risk-on” assets, such as equities and commodities – while interest rates are hovering near zero and the dollar is continually losing value.
Our Conclusion: the Fed’s Zero Interest Rate Policy should support higher multiples going forward.
It may be cliche to say “Don’t fight the Fed.” But essentially, we are not going to fight the Fed.
This week, in MMM: Post-Its and Magic Tape Could Stick the Landing, Paul illustrates a “buy-write” method for buying a stock and selling options on the stock in order to decrease the net cost. Pharmboy continues his Monoclonal Antibody Company review in Monoclonal Antibodies Companies (Part 2). And Richard notes that China (Stock Market) Breaks Higher, and shares a “gambling-money” idea that looks technically good but sets off “greater fool” worries. We’re curious to see how it works out – a trade, not an investment.
Contents of Market Shadows: Lights, Camera, Rally?:
- P/E 10 as a Valuation Gauge = Incomplete Information
- For Stocks, Plenty of Cash But The Will To Commit It Has Been Lacking
- MMM: Post-Its and Magic Tape Could Stick the Landing
- China Breaks Higher
- Monoclonal Antibodies Companies (Part 2)
- Paul’s Prices Virtual Value Portfolio ~ Update (started 10-29, prices 12-17).