Financial planning is always a challenge, but things really are different now. Consider the confluence of unprecedented events:
In addition to the unusually long list of unprecedented events investors face currently, the stock market is expensive by traditional valuation measures.
The trailing price to earnings for the 12 months ended March 4, 2021 was 26.6. For every dollar of profits through the 12 month period ending December 31, 2020, investors in the average stock in the Standard & Poor’s 500 stock index were paying $26.63. The average price/earnings ratio of the S&P 500 since 1961 is 16.6.
But what’s different this time is that the 10-year Treasury bond yield is very low. Although the price/earnings ratio has been a reliable indicator of stock valuations in the past, interest rates are so low that it currently makes the p/e ratio a poor measure of whether stocks are priced too high. Even the Federal Reserve thinks p/e ratios are not relevant for evaluating the risk in the stock market currently.
According to the Federal Reserve Board’s November 2020, Financial Stability Report (FSR), which is published semi-annually, stocks are reasonably priced relative to the yield on a 10-year Treasury bond.
The Fed’s model for evaluating whether the stock market is expensive is shown in this chart. The Fed is not worried about the high p/e ratio of stocks. The Fed is focused on the spread of the 10-year Treasury bond yield versus the current p/e ratio. Since yields are so low, the Fed does not view the high p/e ratios on stocks as a big risk.
“Prices relative to forecasts of corporate earnings have also risen considerably and are currently near the top of their historical distribution, even though there is significant uncertainty in the earnings outlook among market participants,” the Fed says in its most recent FSR “However, while the gap between the forward earnings-to-price ratio and the expected real yield on 10-year Treasury securities—a rough measure of the premium that investors require for holding risky corporate equities—has declined since May, it remains above its historical median due to the low level of Treasury yields. This development suggests that investor risk appetite, though higher since May, is still within historical norms.”
While stocks are currently priced near all-time highs, traditional valuation measures are also higher than normal, and while a confluence of unprecedented events are likely to make stocks more expensive in the days and weeks ahead, the yield curve is nowhere close to inverting. The Fed has caused all of the recessions and triggered most bear markets in stocks in modern history, usually by inverting the yield curve. For example, the Fed inverted the yield curve before the stock market collapse of 2000. Currently, the yield curve is not even close to inverting, giving the Fed room to raise interest rates as the economy continues to recover from the pandemic recession.
This is a time during which professional financial advice is critically important as well as a time to plan and to capitalize on the unusual conditions and opportunities it is spawning.
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