Don't Say You Weren't Warned (Again)

“What The Fed did, and I was part of it, was front-loaded an enormous market rally in order to create a wealth effect… and an uncomfortable digestive period is likely now.” – Former Dallas Federal Reserve Governor Richard Fisher – January 5, 2016.

Throughout 2015 we discussed various measures of evaluating equity prices. All of our analysis points to current equity valuations indicating the market is at an extreme and that poor future returns should be expected. As a result, we have not been shy to recommend investors take a more conservative tack with equities. Indeed, equity market price deterioration in just the first three weeks of 2016 has wiped out nearly two years of gains. While we are uncertain if the recent downturn is the beginning of the anticipated bearish period we expect to materialize, we are certain it is imperative investors better understand the poor risk/reward dynamic of holding equities in the current environment.

On the heels of the frank comments from Mr. Fisher, we thought it would be helpful to share yet another type of equity analysis to help visualize the effect the “enormous rally” has had on equity valuations.

Soaring Price to Earnings Multiples

The scatter plot below shows the strong correlation (r-squared = .75) between long-term earnings growth estimates and the price to forward earnings estimates ratio. This ratio is similar to traditional P/E measures but uses 1-year forward earnings estimates instead of historical earnings data. When long term growth estimates are high, investors tend to be optimistic and likely to pay a higher premium or a greater multiple for earnings. The opposite holds true for lower growth expectations.

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