Today the NASDAQ bounced nearly 3% because the Fed walked back their hardline stance on escalating interest rates. My contrarian view has been that future rate hikes are limited, unless the Fed intentionally wants to crash the economy. I don’t think they want to be responsible for creating a financial crisis, especially since Trump has already placed the blame on tightening Fed monetary policy.
Low interest rates not only stimulate the economy, they are responsible for historically high stock market valuations.
If 10 Year US Treasury yields don’t exceed 4%, then the par benchmark valuation multiple would be a price per earnings ratio (PE) of 25. [ 1 / 1.04 = 25 ]
Therefore, it’s feasible that S&P500 PE multiples will continue to be well above the long term historic norm of 16. Low interest rates correlate to high PE valuations.
Would you rather pay a 25 times premium to own a Treasury Bond or a 19 times premium to own the S&P500?
The chart represents S&P500 levels at various PE multiples, assuming future earnings of $180. [ By the year 2020, moderate 6% growth would put S&P500 earnings in range of $180. ]
During a period of manic investor sentiment, it’s not unreasonable to assume that valuations could hit 22, thus driving the S&P500 to 4,000. A 45% increase from today’s price.
Will the S&P500 get that high over the next 18 months? I don’t know, but given current fundamentals, I see more upside potential than downside risk. In any event, expect high volatility with extreme peak-to-trough price action.
As always, invest with caution.
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