The Fed thinks the stock market is looking a tad on the expensive side.
From the report (emphasis ours):
“Forward price-to-earnings ratios for equities have increased to a level well above their median of the past three decades. Although equity valuations do not appear to be rich relative to Treasury yields, equity prices are vulnerable to rises in term premiums to more normal levels, especially if a reversion was not motivated by positive news about economic growth.”
Put another way, price-to-earnings ratios, or P/E, for stocks look a little high. Price-to-earnings is the basic measure of the price of the S&P 500 divided by the profits, or earnings, of the 500 companies that make up the index.
According to data from FactSet, the current 12-month forward P/E ratio using guidance from the S&P 500 companies to reflect future expected earnings sits at 16.4x earnings as of Friday. The average over the past 10 years is 14.3x earnings.
Just because stocks are expensive doesn’t necessarily mean that they will fall, as the report notes they still look attractive compared with ever-declining bond yields. But the concern expressed in the report is that if negative economic data were to point to a slowdown in the growth of the US economy, the price of stocks could fall back to historical levels.
Stocks are a forward-looking asset, so if the economic outlook is more downbeat, it is likely that that prices, and by extension the P/E, would decline.
And while Yellen and the Fed are cautiously optimistic on the future of the economy and don’t believe that a drop-off is likely, this warning is ought not to go unnoticed.
Update: A previous version of this post included a chart showing the current price-to-earnings ratio of the S&P 500. It has been updated with a chart showing the forward 12-month P/E ratio for the S&P 500 to better reflect the Fed’s assessment of the stock market.