In an otherwise exceptionally dull trading week, markets worldwide reacted violently last Wednesday to Ben Bernanke’s mixed congressional testimony and the Fed meeting minutes released later in the day. Why so skittish?
The “Something Else” Valuation Premium
S&P 500 earnings have doubled and the U.S. economy has grown over $1 trillion since 2008. Household net worth today stands just 2 percent below 2007’s peak. Housing and auto sales have recovered sharply and consumers have weathered cliff and sequester shocks. In the U.S., the argument can be made that today’s fundamentals justify a valuation equal to the long-term average of 15 for the S&P. This does not mean of course that the multiple cannot climb higher. To frame this discussion, if the long-term average PE on the market is 15 (our fundamentally justified number) and the market trades at 25, the additional 10 valuation clicks can be interpreted as a consequence of “something else.” In the 1990s, the additional valuation clicks represented “irrational exuberance.” Today, with the market trading near 17 times earnings, the additional valuation clicks can be attributed to the monetary policy environment. Therefore, using my fundamental valuation vs. “something else” valuation logic, two valuation clicks emanate from Fed policy. With S&P 500 earnings approximating $100, the Fed effect equates to 200 S&P points, or 12 percent of current value. With Fed play accounting for 12 percent of the market value, this explains why markets rallied sharply on Bernanke’s dovish prepared remarks and sold off sharply on his more hawkish remarks in Q&A.
The Truth about Tightening
Is all of this anxiety warranted? David Bianco of Deutsche Bank analyzed the last 15 Fed tightening cycles back to 1965. One month into a Fed tightening cycle, the S&P 500 appreciated .80 percent on average. Twelve months into a tightening cycle the S&P 500 appreciated 4.45 percent on average. Surprised? Don’t be. If the Fed acts on the perception that economic strength may provoke runaway inflation, then corporations should be thriving. It is not the beginning of the Fed’s tightening cycle that mortally wounds markets, it’s the end. Furthermore, the Fed is nowhere near tightening. They have to stop stimulating first. To begin tightening they must become sellers of securities or raise benchmark interest rates.
The current narrative of most money managers is that this market advance is attributable entirely to loose monetary policy and that a shift in policy will produce a shift in markets. They are right about the bond market. If the Fed wants higher rates then rates will rise. The reaction of the stock market is less direct. Yes, this bull will end when the Fed shoots it, but we have to get through not stimulating and beginning to tighten before we get to the fatal stage of over-tightening. While Bernanke may have pontificated about reducing stimulus, he said nothing about reversing it. Look to the economic releases the first week in June for more reliable mile markers.
David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.