Fed Wary On Equity Valuations, Rightfully So

It’s been said that the job of the Federal Reserve, at least as far as monetary policy is concerned, is to take away the punch bowl just as the party is getting started.

Add the stock market to that aphorism.

The Fed said Tuesday (June 21) through its latest Monetary Policy Report that “forward price to earnings ratios for equities have increased to a level well above their median of the past three decades.”

It’s important to note that this is the first time under the Yellen-helmed Fed (extant for more than two years) that there’s been a strong whiff of concern about valuations, with the “well above” a key bit of language, especially against a backdrop where there had been nary a peep when the markets were, roughly a year ago, at or near all-time highs.

The implication is that with the stock market having rebounded roughly 15 percent off nadirs seen near the beginning of this year (as measured by the broader S&P Index), when the Fed said valuations were at averages, there’s reason for concern, fundamentally speaking.

The forward PE ratio is at 16.5x, up from 15.4 at the beginning of the year – and the median over the past several decades has been 14.8x.

Why the sudden concern? One tell may be the fact that Yellen said during testimony that although she expects the U.S. economy to grow, there is a nod to potential pitfalls, such as Brexit, which will or won’t be a reality soon enough, and consumer spending, which drives just about everything.

The fact that interest rates are likely to stay low – because, really, what else can the Fed do on that front, with rate hikes being pushed out? – means that valuations by default must remain high because money must chase returns.

The valuations are only part of the story. The Fed has in the past given the nod to worries over the stock market, perhaps most famously Alan Greenspan’s “irrational exuberance” sound bite.

For payments and for tech, the high valuation scenario has another implication. The historically high valuations (that is, significantly above the median) mean that execution must be flawless for those companies that come to market – if they ever do. The stage is set for a tightrope walk, and volatility amid geopolitical concerns only makes the tightrope shakier.  Small wonder then, that the IPO climate has been chilly at best.  The Fed is eyeing the punchbowl, after a long time as wallflower at the party, and the guests are right to be nervous.