In the years following the financial crisis, it became easy for Wall Street to ignore projections from the Federal Reserve. Relying on models built from data describing much less significant recessions, Fed economists consistently overestimated the speed at which the economy would recover and the pace at which the central bank could normalize interest rates.
Today, the market is much more optimistic that the Fed will be able to raise inflation above its 2% annual goal, and that the U.S. economy will grow closer to 3% this year than the 2% averaged during the previous eight. A recent survey by Bloomberg shows that Wall Street economists predict that Wednesday’s rate hike will be the first of four, while the median FOMC member sees just three. Meanwhile, the consensus estimate of first-quarter growth is 2.7% on Wall Street, whereas the Atlanta Fed’s GDPNow tracker is now indicating growth of 1.8%, after disappointing retail sales and housing start numbers have suggested that the economy isn’t as heartened by the recent tax cuts as many had expected.
This optimism is rooted in a faith in corporate tax cuts and a laxer regulatory stance by the Trump Administration, and it is manifesting itself in an ever-expanding price-to-earnings ratio. While the tax cut is expected to boost corporate earnings by about 5%, the market has bid up equity prices even higher, with the S&P 500 costing 17.1 times forward-looking earnings, up from 16.5 two years ago.
The expanding ratio of stock prices to earnings isn’t a new phenomenon. In fact, the stock market has been getting steadily pricier since the end of the recession. It has even led bearish observers, like GMO’s Jeremy Grantham, to predict that we should expect the market’s cyclically-adjusted price-to-earnings ratio (CAPE) to revert to a higher level today than it did before 1997, in part because interest rates are on average lower today than in the past. But even if you assume that the CAPE ratio will revert to levels somewhat higher than in the past, the market today remains overvalued.
“US CAPE ratios are at levels previously reached only in 1929 and during the tech bubble. In the fall of 2017, the US stock market surpassed a CAPE ratio of 32, nearly double its long-term historical norm of 16.6,” writes Research Associates Rob Arnott in a recent analysis. He argues that there are short-term factors, like the persistently low interest rates seen since the recession, for higher-than-normal valuations. But a lower discount rate also suggests “low expected returns for many years to come, even without any mean reversion in the CAPE ratio.” What’s more, if low interest rates evaporate, Arnott writes “then we’ll get mean reversion in CAPE and possibly as a severe market downturn.”
In other words, the market can justify higher multiples if interest rates stay low, but market participants are increasingly signaling their confidence that the interest rates will rise this year and next, along with economic growth and inflation. But justifying CAPE ratios well above even the trailing 10 year average requires that interest rates remain at historically low levels.
Another argument for the medium-term persistence of high valuations is that Corporate America has yet to absorb the benefits of lower taxes and regulatory reform. But even the typically sanguine Fed is predicting that the U.S. economy will not reach the Trump Administration’s 3% target, this year or during the remainder of the president’s term. Meanwhile, it predicts that unemployment will bottom next year before steadily rising thereafter, indicating there isn’t much room for consumer spending power to rise from here.
In other words, the U.S. economy is growing above potential as the corporate tax cuts are testing just how much fiscal stimulus markets will tolerate. That alone should make investors question just how much higher this bull market can climb. Meanwhile, debt levels in the U.S. and China — the global economy’s twin engines of growth — continue to rise faster than their respective economic growth rates, suggesting that public and private sector actors may be growing complacent.
Christopher Matthews is a writer who splits his time between New York City and Accra, Ghana, with an interest in the intersection of markets, the economy, and public policy. He previously held staff positions at Axios, Fortune Magazine, and Time Magazine, and has been published in Forbes and Debtwire.