Aggressive Fed Paves Way for Worries over Stock Valuations

Some investors once again think that US equities have become expensive, as the hawkish comments of the Federal Reserve pushed up bond yields and market participants were driven to reassess stock valuations.

Stock valuation

A common metric used for stock valuation is the forward price-to-earnings ratio of the S&P 500. After equities recorded a sharp rebound from their lows in mid-June, this metric has gone up to 17 times earnings.

At the start of the year, the forward P/E had been around 22 times, which means the current value is far lower.

Earlier this month, the valuation may have been deemed acceptable because the markets had rallied on hopes that the US Fed would adopt a more dovish stance sooner than anticipated.

However, all those hopes were dashed when chairman of the Fed, Jerome Powell, delivered his speech last Friday in Jackson Hole, which was unambiguously hawkish.

According to some investors, there need to be further declines in stock valuations for reflecting the risks of a looming economic recession and increasing bond yields.

At the end of the second quarter of 2022, one of the major positives for the market were the comparatively modest stock valuations.

This was when stocks had reached their lowest levels recorded in the last year in a half, after taking a beating for six months, and the forward P/E had been just around 15 times.

Risk not priced in

Market analysts said that stocks has rallied almost 10% from the lows recorded in mid-June and they have not priced in the appropriate amount of risk.

They said that this was something the market would have to deal with in the second half of the year. The rising Treasury yields are a danger to equities, which have accelerated because of the Fed’s stance.

The US central bank is committed to raising interest rates more than what had been anticipated by the markets previously.

Equities are usually under pressure when Treasury yields rise, as they are inverse to bond price. This is because US government bonds are regarded as a risk-free option as opposed to stocks.

Rising yields

Climbing yields are particularly a problem for companies that are operating in the tech sector, as these form a significant part of indexes like the S&P 500 and their expected future earnings are high.

Therefore, it is these companies that see their valuations take a hit when yields rise. The 10-year US Treasury yields rose to their highest level of 3.5% recorded in a decade.

This was when the mid-June low had been recorded by the S&P 500. The 10-year yield dipped during the summer, but bounced back to 3.1%.

Thus, there has been a decline in the equity risk premium, which is the extra return that investors get for investing in stocks as compared to government bonds.

It has come down to its lowest level since 2009, which has prompted analysts to recommend that investors focus more on commodities and fixed income, rather than stocks.