Are Stock P/Es Too Low? Apparently The Fed Thinks So

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Includes: DIA, IVV, QQQ, SPY
by: Bruce Carlson

Summary

The Federal Reserve's monetary policy is at an unprecedentedly easy level for this point in the economic cycle.

There is a correlation between the level of Monetary Policy and the stock P/Es priced into the market.

Given this unprecedentedly easy monetary policy P/Es should be even higher than they currently are.

In my prior article Will the Fed Shock the Markets I demonstrated using the real fed funds level and the unemployment rate that the level of Fed stimulus at this point of the cycle is unprecedented. In addition I created a simple indicator to succinctly show the level of this stimulus.

Data sourced from the Federal Reserve (FRED).

Data sourced from the Federal Reserve and my own calculations.

From this policy indicator we see that both the level and duration (area under the curve) of Fed stimulus is the greatest it has been over the last 50 years.

When we extend this analysis to see what the level of Federal Reserve stimulus plays in the level of stock prices, we see a causal relationship. Since the modern Greenspan era of the Fed, we see a relationship between the level of monetary policy and the Price to Earnings Ratio (P/E) of the S&P 500 index, where the easier Fed policy is the greater S&P P/Es tend to climb (calculated on a trailing 12 months earnings basis).

Data sourced from the Federal Reserve and my own calculations.

If we look at the relationship between the amount of Fed stimulus and the level of stock P/Es it holds up relatively well. The main area of disconnect is in the mid 90's at the start of the internet era as stocks benefited from the productivity revolution and the transformation these new technologies provided even as monetary policy remained relatively stable. And in 2009 the relationship is somewhat exaggerated as the write downs from the financial sector dramatically diminished S&P earnings and caused P/Es to skyrocket as the Fed eased policy to mitigate the stock market declines.

If we review this relationship, with the extremely accommodative Fed policy currently in place (which is greater than we have seen over the last 50 years) it would indicate P/Es should also be reaching extreme levels. If we correct for the 2009 and 2010 inflated P/Es and run a regression the results would suggest P/Es should be at a level 9% higher than current levels, with the error more likely to be skewed towards higher P/Es and higher stock prices.

This would be consistent with Warren Buffett's sentiments as expressed on CNBC Monday, where he views the market as fairly priced or even under valued given the current level of interest rates.

This suggests that either the Fed is going to get much more hawkish and aggressive in moving policy tighter or the stock market will continue to "melt upward" in an extended rally.

I personally believe the Fed will start to be dramatically more aggressive going forward with the Fed speeches on March 3rd, just ahead of the March meeting's the silent period, being the date where this policy shift begins to be unveiled. I would be cautious of this date and buy volatility where it is attractively priced covering this date and the March 14-15 meeting.

If the Fed does not come out aggressively then equities continue to look attractive, barring the greater than normal political risk of the new Trump administration, and long equity positions should continue to be profitable once the current overbought conditions are relieved.

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.