Never before has a rally in the U.S. stock market gone on this long without a Federal Reserve interest-rate increase. Expecting valuations to keep rising once one comes is asking too much, if history is any guide.
While Standard & Poor’s 500 Index price-earnings ratios are far from records, they’ve shown no ability to expand after the U.S. central bank starts raising rates, according to data compiled by Goldman Sachs Group Inc. and Bloomberg. In the quarter after the last 12 tightening cycles began, P/Es contracted by an average of 7.2 percent.
It’s something else to worry about as the Fed prepares to lift rates in an economy that is still far from booming. Should policy makers move before January, they would be doing so in a year when U.S. profits are forecast by analysts to increase 1.4 percent. That represents the weakest growth at the start of a tightening cycle since 1980.
“You can’t count on multiple expansion,” Mark Spellman, a fund manager who helps oversee $4.2 billion at Alpine Funds in Purchase, New York, said by phone. “It doesn’t necessarily mean some death knell or a bear market is coming. But it does put a lid on equity gains.”
Since P/Es reached their bull market bottom of 11.9 in October 2011, multiples for S&P 500 stocks jumped to 18.3 in December, rising in each calendar year to help push the index up 87 percent. At 18.5 today, the index’s valuation is more than 2 points above the 10-year average and expanding at the slowest rate in 3 1/2 years.
S&P 500 futures were little changed at 10:37 a.m. in London.
As for profits, analysts are cutting projections at the fastest pace in six years after earnings rose at an average rate of 15 percent annually since 2009.
The confluence shows the risk to equity investors amid a bull market that has restored $17 trillion to American share prices since 2009. While stocks have usually come out of past tightenings with gains, investors are in uncharted waters after the advance recently became the second-longest in six decades.
“The market is overdue for a healthy correction and the Fed tightening is likely to be the catalyst,” said David Lafferty, who helps oversee $900 billion as chief market strategist at Natixis Global Asset Management in Boston. “It’s more the sentiment. It’s the idea that the central bank is explicitly doing something to tighten monetary policy.”
Friday’s employment report offered evidence the economy is picking up speed, with payrolls climbing 280,000 in May, the most in five months, as hourly earnings rose. Still, with gross domestic product increasing at an average rate of 0.9 percent a quarter since 2009, the recovery since the last recession is the weakest since World War II.
Higher rates haven’t always snuffed out bull markets. The S&P 500 rose an average 2.9 percent in the 12 months following the first increase in 12 tightenings since 1946, according to a Ned Davis Research study on market returns and monetary policy.
Equities performed better when increases were spread out rather than at back-to-back Fed policy meetings. Gains averaged 11 percent, the data show.
The consequences of Fed actions are more complicated than what shows up in valuations and investors who make decisions based on the direction of rates are making a mistake, according to Aswath Damodaran, professor of finance at New York University’s Stern School of Business. The contractions in multiples following past tightenings aren’t out of line with normal volatility in P/Es, data compiled by Bloomberg show.
“Rate movement is almost never going to happen in a vacuum,” Damodaran said by phone. “If rates go up because the economy is going stronger and you ask me what the effect on stocks will be — it depends. It depends on how much the economy getting stronger pushes up earnings.”
“This whole notion of freezing everything else and just looking at the effect of interest rates is misguided. It’s going to lead you down all kinds of wrong paths,” he said.
The S&P 500’s multiple has climbed 62 percent since September 2011, the third-fastest since 1982 and compared with an average increase of 48 percent in the previous nine trough-to-peak cycles, data compiled by Goldman show.
While higher interest rates signal a strengthening economy, stocks that have tripled in value since 2009 are vulnerable should investors become reluctant to pay a higher multiple and earnings fail to make up for the gap, said Bob Doll, the chief equity strategist at Chicago-based Nuveen Asset Management.
“The easy money in the bull market is made in the first half when interest rates are falling and earnings are rising,” said Doll, who helps oversee $130 billion. “The second half of the bull market, stocks tend to go up in a much bumpier and slower pace because rates are slowly moving up and P/Es begin to be challenged.”
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