S&P 500: A Bubble Fueled By The Fed

| About: SPDR S&P (SPY)
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Summary

The S&P 500 is trading at historical high valuations in terms of Price-to-Earnings and Price-to-Sales due to the Fed's ultra-loose monetary policy.

Be careful with the flawed argument that current stock valuations are justified because the equity earnings yield is higher than the Treasury yield.

Be careful with the flawed argument that equities offer a higher dividend yield than Treasuries.

A bubble that started with Central Banks' unprecedented ultra-lose monetary policy will end when Central Banks normalize their policy.

Expensive Valuations

This week I wrote an article showing that the S&P 500 (NYSEARCA:SPY) (NYSEARCA:VXX) (NYSEARCA:IVE) (NYSEARCA:SH) (NYSEARCA:VOO) (NYSEARCA:SSO) (NYSEARCA:SDS) (NYSEARCA:IVV) (NYSEARCA:SPXU) (NYSEARCA:UPRO) is trading at an historical high valuation.

In fact, the current P/E is at 25.09 (when the historical average is 15.61), the Shiller P/E is at 26.93 (when the historical average is 16.69) and current Price-to-Sales is at 1.92 (when the available historical average is 1.48). For the S&P to trade at its historical average it would need to correct between 23% and 38%, depending on the metric used.

In the same article, I explained that this bubble is being fuelled by the Fed (and other Central Banks) ultra-loose monetary policy. In this regard, normalization of monetary policy poses a big threat to current equity prices (as well as real estate, fixed income, commodity and all other asset classes).

Today's article will build on the outlook I shared on the previous one so I suggest you read it before jumping into this.

The first counter argument

Some investors argue that current equity valuations are justified because the equity earnings yield is higher than the Treasury yield.

Let me start by saying that this is a relative judgment arguing on which asset class is less overpriced. It does not deny the fact that both asset classes are expensive in absolute terms (thanks to the Fed's ultra-loose monetary policy). In fact, the equity earnings yield (currently at 3.97%) is at an historical low level while the 10 year US Government bond yield (currently at 1.60%) has never been so low.

S&P 500 Earnings Yield:

US 10 Year Government Bond Yield:

Source: Multpl

Second, this is only half the story because any investment must be seen from a risk / return perspective. Even though equities currently offer a higher yield than Treasuries we can't forget they are way more volatile than bonds.

Third, it is true that in the long term both the equity earnings yield and the bond yield move together. However, in the short term the equity earnings yield is much more volatile because it is more sensitive to economic cycles than Treasuries. In fact, investor shouldn't forget that we're probably at the end of an 8-year bull market and a recession will push company earnings lower.

The second counter argument

Other investors argue that equities offer a higher dividend yield than Treasuries.

Once again, this is a relative judgment that does not deny the fact that both equities and bonds are overvalued. In fact, the equity dividend yield is at an historical low level (currently at 2.04%).

S&P 500 dividend yield:

Source: Multpl

Second and again, this is only half the story. It is true that the S&P 500 dividend yield (currently at 2.04%) is higher than the 10 year Government bond yield (currently at 1.60%). However, while interest must be paid (otherwise the issuer will enter in default), no company is obliged to pay dividends. Dividends can be lowered, increased or canceled for any period of time.

Third, the S&P 500 dividend payout ratio (the percentage of net income distributed to shareholders in the form of dividends) is at the highest level since 2009. A high payout ratio brings into question how sustainable are the companies dividend policies. It also means that companies are left with less money to invest, which affects future earnings. Even though in Europe things look even more stretched, don't forget that US companies often complement their dividend policies with share buybacks (which is a less common practice in Europe).

Source: Wall Street Journal

In Summary

The way I see it: we're in a bubble. Of course, markets can remain irrational longer than you and I can remain solvent. So, the key question is timing.

To answer that question, my view is that the bubble that started with Central Banks' unprecedented ultra-lose monetary policy will end when Central Banks normalize policy. Of course, the longer they take to do it, the bigger the bubble will get. That's why they carry on warning they'll raise rates (in a failed attempt to avoid further asset price increases), but in the end never do it (because they know they'll crash the markets when that happens).

Carry on dancing, but be careful, because DJ Janet could change the song sooner than we think.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.