The Fed rhetoric is likely to turn somewhat more hawkish in advance of a December rate hike, and the higher U.S. rate expectations will push up the dollar, further curbing S&P 500 profit growth. Our report explores the latest trends summarized here.
After a brief plunge following the Brexit vote, global stocks have been on a tear. The MSCI All-Country index has risen by 10.8% from its June lows, while the S&P 500 has gained 9.1%, reaching a new record high. The dramatic rally in global bourses has raised the odds of a nasty correction. While we are not calling for a sustained selloff, investors would be wise to take some money off the table.
Priced For Perfection
U.S. stocks, in particular, appear increasingly priced for perfection. The forward P/E ratio for the S&P 500 has risen to 18, well above the post-1980 average. The median stock now trades at a record P/E ratio of 21 – even higher than at its peak in 2000 (Chart 1). Other valuation measures such as the Shiller P/E, Tobin’s Q, market cap-to-GDP, and price-to-sales all point to below average total returns for U.S. stocks over the coming years.
Buyback Activity Has Dimmed
Diminished buyback activity could also weigh on stocks. Goldman Sachs estimates that the value of all buyback announcements declined by 30% in the first half of 2016 compared with the same period in 2015. Although this number is somewhat distorted by several high-profile announcements last year, the overall story of decelerating buyback growth remains intact. This is consistent with data from TrimTabs, which shows that buyback authorizations plummeted to the lowest level in four years during the recently completed Q2 earnings season.
Higher Rates Will Prop Up The Dollar
Granted, today’s low dividend yield still exceeds the 10-year Treasury yield. But therein lies the risk: If Treasury yields move higher, the relative value of stocks over bonds will fade. Chart 6 shows that the market is pricing in only 38 basis points in rate hikes through to end-2018. While we have long argued that interest rates are unlikely to rise anywhere close to pre-crisis levels, today’s market expectations are too dovish even for our taste.
Political risks could pose a further headwind to stocks. Chart 8 shows that the S&P 500 has tended to react negatively whenever Donald Trump has moved up in the polls. The reverse pattern has been evident for the dollar and Treasurys: As “risk-off” assets, the latter have tended to strengthen whenever the odds of a Trump victory have risen.