Yellen leaving stocks’ fate to elusive earnings

Past hikes have almost always put a ceiling on S&P 500 Index’s price-earnings ratios

It’s hard to know which would be worse for US equity investors right now: a contraction in valuations, or if stocks were left to rely on earnings growth to push them higher.

Both are likely outcomes of this week’s Federal Reserve meeting, where policymakers are poised to raise interest rates for the first time in 9 1/2 years. Past hikes have almost always put a ceiling on Standard & Poor’s 500 Index price-earnings ratios, and one now would come at a time when profits are already in decline. Such a combination hasn’t occurred in five decades.

The one-two punch is part of Goldman Sachs Group Inc.’s forecast that equities will go nowhere in 2016. The bank pins most of its pessimism on valuations, which would be a concern regardless of whether the Fed were meeting. At 21 times annual income, the S&P 500 is trading higher than it was at the end of eight of the past 10 bull markets.

“Raising interest rates is the equivalent of putting a brake to a car,” said Rich Weiss, the Mountain View, Californiabased senior portfolio manager at American Century Investment, which oversees $146 billion (Dh536 billion) and favours European stocks over US equities. “No question it’s dangerous with slow or no earnings growth, relatively high multiples and arguably an economy that’s stagnating.”

Fed Support

Should the Fed tighten, it would be retreating from support that has contributed to one of the biggest bull markets, an advance that could become the second-longest on record in 2016. Seven years of nearzero borrowing costs have helped corporate profits double since 2009 and fuel a boom in takeovers and buy-backs.

While Fed Chair Janet Yellen has pledged to raise rates at a gradual pace, history shows the negative effect on equity valuations is almost inevitable. Over the past 70 years, the S&P 500’s price-earnings ratios shrank during the first year in 10 out of the 12 Fed tightening cycles, falling an average 15 per cent, according to data compiled by Bloomberg, Ned Davis Research and S&P Dow Jones Indices.