FEDERAL RESERVE WARNS: Stocks are looking expensive

The Fed thinks the stock market is looking a tad on the expensive side.

As part of Chair Yellen’s testimony to the US Senate Tuesday, the Federal Reserve released the Monetary Policy Report and highlighted a worrying trend in the price of the stocks.

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 (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.

The average P/E since 1960 is roughly 16x earnings. Current P/E for the S&P 500 is just under 24x as of Friday.

Just because stocks are expensive doesn’t necessarily mean that they will fall, as the report notes they still look attractive compared to 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 Federal Reserve 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.

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