- The S&PP 500’s price-to-earnings ratio has reached its highest level in almost two decades.
- The benchmark index is nearing all-time highs, having recovered 43% from March’s bear-market low.
- Volatility is gradually returning to its historically neutral range, a move that is generally positive for stocks.
The stock market’s miraculous recovery over the past two months comes with one nasty side-effect: extreme over-valuation risks.
S&P 500’s Frothy Valuation
The P/E ratio measures a company’s current share price relative to its per-share earnings. A high P/E often means that a market’s current price is not justified by its earnings outlook.
The elevated P/E comes even as many corporations revised or pulled their forward guidance due to the pandemic. As of Friday, 27 S&P 500 companies had issued negative earnings guidance for Q2 compared with 21 that issued positive guidance.
Only 48 companies have issued forward guidance for the second quarter, which is less than half of the five-year average.
An ‘Uncomfortable’ Rally
Stocks have rebounded more than 43% from their March lows thanks to unprecedented Federal Reserve intervention and optimism about a broad economic resurgence. The bulls were vindicated on Friday after the Labor Department reported a net gain of 2.5 million jobs in May.
As the S&P 500 inches closer to record highs, Allianz’s Mohamed El-Erian says the rally is making him “uncomfortable.”
The economist, who correctly predicted the pandemic-driven bear market, told CNBC:
For me personally, it’s an uncomfortable bet to continue to bet on a huge recovery… I don’t like doing this. But I respect and admire those who can.
Despite their ‘win-win’ attitude, investors are failing to consider the long-term impact of Fed intervention in the market.
The Fed’s balance sheet has been growing since September when the overnight repo market suddenly went haywire. But the pace of intervention has skyrocketed since March as all levels of government scrambled to prop up a sinking economy.
As the Fed’s liquidity boost keeps money flowing into the stock market, new all-time highs for the Dow and S&P 500 could be on the immediate horizon. In the meantime, the U.S. dollar could be headed even lower.
A measure of expected volatility is also returning to its historical mean, offering another sign that the worst of the market selloff has passed.
The CBOE Volatility Index, commonly known as the VIX, is back around 25 on a scale of 1-100 where 20 represents the average.
VIX peaked in the high 80s in March as the S&P 500 crashed into bear-market territory.