Tuesday, 23 October 2012

US stocks outperform as Fed easing pushes valuations above historical norms

Bloomberg reports that US stocks are beating every major asset class for the first time in 17 years.

The Standard & Poor’s 500 Index has rallied 14 percent in 2012, beating Treasuries, corporate bonds, commodities, the dollar and equities in Asia and Europe, data compiled by Bloomberg show. The last time that happened, in 1995, the S&P 500 was posting the biggest annual advance of the last five decades. With a price-earnings ratio close to today’s level, the index gained another 93 percent in the next 2 1/2 years.

However, Brett Arends says stocks may actually have become expensive by historical standards.

Over the past 130 years, U.S. stocks on average have traded at about 17 times mean earnings for the previous 10 years—a measure known as the "Shiller Price/Earnings Ratio" after Yale economics professor Robert Shiller, who tracks the data. Today the market is about 22 times those earnings, a level associated with frothy markets such as 1929, the mid-1960s, and most of the period from 1995 to 2008.

Another measure, "Tobin's q," also suggests stocks might be in dangerous territory. Tobin's q, named for the late Nobel economics laureate James Tobin, measures stock valuations against the cost of replacing companies' assets. Right now the reading is 0.92, about 50% above the long-term historical average. Stock returns from these levels have usually been subpar.

Barry Ritholtz says that the Federal Reserve's quantitative easing has “made riskless assets much less attractive” and “forced managers into equities beyond what is normally prudent”.

The Fed’s impact on asset prices will eventually attenuate. Those of you who are playing along at home, make sure you have some set of parameters to alert you to evidence of when the Fed’s punchbowl has gone non-alcoholic so you can reduce your equity exposure substantially.

We continue to get closer to that point, but we are not quite there yet . . .

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