Have stock markets rocketed too high ?

ANALYSIS | 07/18/2014 15:36:11 GMT

The zero rate policy has encouraged the rally in asset prices
On stock markets, valuation levels are still acceptable

Is the US Federal Reserve inflating a new bubble? In her semi-annual report to Congress, Fed Chairman Janet Yellen said that “The [Federal Open Market] Committee recognizes that low interest rates may provide incentives for some investors to ‘reach for yield,’ and those actions could increase vulnerabilities in the financial system to adverse events.” Yet she added that although asset prices have risen appreciably, “they remain generally in line with historical norms.” But what about the rally in the US stock markets? The S&P 500 – now at around 1,980 – is flirting with its record high on 3 July 2014. It is up 7% since the start of the year, after gaining 30% in 2013 and 13% in 2012. Now those share price gains need to line up with the earnings curve (see chart). The cyclically-adjusted P/E ratio currently stands at around 20, which corresponds to an earnings yield of 5%. That’s 2.5 percentage points higher than the “risk-free” rate on 10-year government bonds. And according to the simplified framework in Fed model, that’s an acceptable valuation level. The dangers may lie elsewhere – such as with high-yield bonds. Spreads on those bonds appear to be less and less correlated with the underlying risk.

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