U.S. Stocks: Heading For A Bubble?

A global resynchronized recovery is good news for corporate profits. But better profit growth is no longer news for the stock market because the S&P 500 has already discounted a 10% increase in forward earnings in the next 12 months. Therefore, if stock prices make continued advances, the expected price gains will have to primarily come from a multiple expansion.

BCA U.S. Equity Valuation Index

U.S. equity prices are no longer cheap. Various valuation indexes suggest the market is either fairly valued or borders on slight overvaluation. Nonetheless, macroeconomic and financial conditions are conducive for further P/E inflation. There is a clear link between equity multiples and the yield curve. A steeper yield curve is indicative of better growth and very easy monetary policy. As such, it often coexists with expanding equity multiples.

If our macroeconomic story of synchronized global growth with low inflation plays out, then the yield curve will likely stay rather steep for a while longer: the long end of the curve will be held high by real economic growth and better profitability, while the short end of the curve will be suppressed by the Fed. This creates fertile ground for asset price inflation.

In addition, once in a liquidity trap where interest rates reach the zero boundary, the linkage between monetary policy and the real economy is asset markets: zero rates act to subsidize corporate profits, drive up asset prices and encourage risk-taking. At present, we could be at the very early stages of a broad transition from strengthening asset values to better spending power by businesses and consumers. Nonetheless monetary policy will stay extremely easy to ensure this process takes hold firmly.

Bottom Line:
We are still operating in an environment where monetary conditions are hyper stimulative and inflation is extremely low, and corporate profits will accelerate. This environment ferments asset bubbles, and underscores why there are high odds that equity prices move into bubbly territory next year.

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