Fed's easy-money move casts a pall over profit growth
Economy still in need of support may not be strong enough to produce robust earnings
The euphoria with which investors in the US stock market greeted the Federal Reserve's decision to stick with its easy-money policy has begun to evaporate, as the message the Fed was sending about a less than stellar economy sinks in.
An economy still in need of a safety net may be too weak to produce robust earnings growth, meaning the valuation of the S&P 500, now at its most expensive on a price-earnings basis since 2010, becomes harder to justify.
The index has jumped 20 per cent this year and hit new highs last week, boosting its forward PE ratio to 14.94, its highest since early 2010. At that time, though, company earnings were improving more rapidly than now, as business activity rebounded from the depths of the recession and financial crisis in 2007-09.
Profit growth is expected at about 6 per cent this year, a far cry from the 31 per cent achieved in 2010. That undermines the case for further gains in stock prices and has led some investors to consider reducing their earnings forecasts.
"The Fed's no-confidence vote in the economy really causes us to revisit our profit estimates for the rest of this year and next," said Leo Grohowski, chief investment officer at BNY Mellon Wealth Management in New York. "I would not be surprised to see consensus numbers get adjusted."
Investors are more likely to be prepared to pay higher prices for shares if they think earnings are expected to rise, so if profit expectations fail to materialise, valuations could be stretched.
Markets had expected the Fed on Wednesday to cut back on its US$85 billion a month in bond purchases, which have been behind its efforts to spur economic growth and have injected money into the financial system.
Instead, the Fed kept its stimulus in place and cut its projections for economic growth this year and next.
Despite the weaker forecast, stocks jumped, but on Thursday and Friday, the markets largely gave back the gains, partly amid fears of a government shutdown or debt default because of a deadlock in Washington, but also because of concerns that prices had become overextended.
Now, investors' focus in the next few weeks is going to be on Congress and third-quarter results, which will help show whether the Fed's prudence was warranted.
Growth has slowed substantially since the peaks of this earnings cycle. For the second quarter, earnings increased 4.8 per cent, the 15th consecutive quarter of S&P 500 profit growth.
The S&P 500's big gains this year have driven up the forward PE ratio from 12.7 at the end of last year. Multiple expansion has come as investors bet on improved growth that would allow the Fed to reduce its support for the economy.