History shows that valuations don’t matter until they do. The challenge is gauging what will cause investors to balk at current multiples, which have vaulted to elevated levels.
Monetary policy uncertainty is a potential candidate: reduced domestic liquidity would force profits, which have entered a difficult phase, to become the primary driver of capital appreciation.
A dearth of pricing power, rising wage expenses and a strong U.S. dollar together put a serious dent in earnings growth projections. The strong dollar on its own is a tactical valuation warning. The narrowing yield curve is another signal that the market is not comfortable with the Fed’s judgment that the economy can handle and even needs higher interest rates, another threat to valuations.
A number of other factors could still cause valuations to reset. Economic data is undershooting expectations in the U.S., even though momentum has picked up abroad. This reinforces that foreign QE programs are redistributing growth via currency weakness rather than lifting global final demand in aggregate. The forward P/E and economic surprises have also trended together since the Great Recession.
The market has ignored the recent downturn in inflation expectations. The latter is an excellent indication for S&P 500 sales, and by extension, corporate profit growth. The gap that existed since 2013 can be explained by QE, i.e. investors were content to overlook deflation threats because the liquidity taps were still gushing. But now that the Fed is telegraphing a path to tighten, it is possible that the gap will close.