The week looks like finishing on a very different note to the way it started. The equity rally continued post the Federal Reserve’s decision to keep the word considerable in the press release accompanying the rate announcement. Fear appears to have turned rapidly to some end of year greed as equity markets have rallied circa 5% from their lows.
We continue to live in strange times; the downside potential of deflation and political turmoil could in theory be substantial for risk assets. When these fears resurface it leads to bouts of de risking, the like of which we have seen over the past few days. On the plus side equity yields remain attractive particularly in comparison to corporate bond yields.
Low bond yields are potentially a double edge sword. On the one hand they suggest a lack of global growth, which is negative for equity pricing, whilst at the same time make equities look attractive on a yield basis.
We have in the past discussed the principle of equity risk premium, which is defined as the difference between the implied equity return (1/ price earnings multiple) and the current 10-year bond yield. In the UK the equity risk premium is approaching 6%, the top end of the historic range. On a price earnings basis on 13x the FTSE 100 is close to the top end of its valuation range. One can easily see how the current level of discount rates makes equities look attractive, and a rising discount rate will lead to lower asset values. This is partly the reason so much weight is put on the federal reserves monetary policy statements.
The S&P 500 is now more expensive than it was in 2007 on a price to sales matrix but not quite so stretched on price earnings multiple. This is a reflection of how CEO’s have managed to eek out productivity gains in a low economic growth environment. This why analysts focus on margins, any signs that margins are coming under pressure without any signs of pick up in revenues will get them sharpening up the red pencil.