Equity Rally Sustainability: What To Look For

247Bull.com Editor: The p/e ratio on the S&P 500 index reached a high in December 1999 of 57, and a low in September 2011 of 12. The average has been around 26. Today however, it is around 15. Therefore, in terms of value, the S&P 500 is neither particularly cheap nor particularly expensive.

The Dow has broken above its previous cyclical high in 2007 and the S&P 500 is close to doing the same. Investors are piling in, but many are nervous that the rally is perhaps solely based on Fed policy. How will investors know when the equity market can stand on its own, without constant shots of monetary stimulus to keep it going?

The equity risk premium has fallen from its peak, but this has been largely based on a moderation in perceived tail risk rather than stronger growth. Indeed, real GDP growth has struggled so far in this recovery to sustain even a trend pace of 2-2½%. In turn, sub-par growth has kept the FOMC under pressure to continually look for ways to provide additional stimulus. Perceptions among policymakers and investors regarding the sustainability of the recovery will change when real GDP growth finally shifts to an above-trend pace.

Three key market indicators will signal a shift in perception. First, gold prices should fall in absolute terms and relative to broad commodity indexes. Gold is a liquidity play and its relative performance is highly correlated with risk aversion.

Second, bank stocks should outperform relative to the broad market and rise in absolute terms. This sector provides a read on financial systemic risk.

Third, and most importantly, rising real bond yields would highlight that the economic recovery is becoming self-reinforcing and can handle a gradual withdrawal of monetary stimulus.

The bottom line

All three indicators are flashing ‘green’ at the moment.

Article courtesy of http://bcaresearch.com

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>