The last few years have seen US Equities following a near linear trend as quantitative easing dumped bucket loads of cash into the economy which inevitably sought yield in the equity markets. Despite the historically high level of stock valuations, the Fed has remained quiet and relatively dismissive of the idea that they had created an asset bubble.
However, that may have changed this week as the latest testimony from Janet Yellen cautioned that equities had “increased well above the median of the past three decades”. Subsequently, the canary in the coal mine might have just croaked and only now is the Fed warning that there is a problem afoot.
It is no surprise to most market strategists that the Fed is largely responsible for the growth in stock valuations over the past few years. This is especially evident given that the bull market largely matches the various tranches of QE whilst being further buoyed by the low rate environment.
In contrast, S&P 500 earnings have remained relatively flat in the aggregate whilst share buyback schemes have been the financial engineering tool of choice throughout 2016.
However, in true Wall Street fashion, most market analysts are purely interested in sell side research and therefore have little interest in pointing at over-heated markets. Subsequently, it has really been anyone’s guess as to who would finally call “uncle” on the current valuations.
What is surprising is that Janet Yellen is largely the first public official to point at the rising risk profile of equities and to caution about their high forward P/E ratios. Given that the chief instigator of the bubble is now warning of rising risk makes me wonder just how much the central bank is concerned about a correction.
However, regardless of the cautionary tone of the central banker’s statement, the reality is that in the current low rate environment equity prices are likely to remain buoyant. Given that global growth forecasts are fairly lacklustre, I do not foresee sustained interest rate hikes any time soon.
Subsequently, if the air does come out of equity markets it will be in a slow and orderly fashion. However, if inflation stirs in the near term and necessitates the sustained tightening of monetary policy, stocks could be at a very real risk of a correction.
Ultimately, like any investment portfolio, risk needs to be managed and the smart money is already doing this by rebalancing their portfolios with a range of other asset classes. Subsequently, although I don’t foresee a market crash in the short term, if you are equity heavy it might be time to rethink the asset mix of what you currently hold.