October 16, 2018
Australian Markets Weekly – stock market valuations – how overvalued?
This week, we're reproducing a thematic piece on US stock market valuations.
- By last Thursday, the S&P500 had fallen -7.1% since 3 October. (The market had an uneven bounce on Friday.) Is this a minor correction or will it become something larger? While we do not pretend to have that answer (timing is difficult), it is clear the stock market is expensive on most metrics especially given the cost of capital is being re-priced as interest rates rise.
- How overvalued? Using a valuation framework by the San Francisco Fed, stocks are 13-27% “overvalued” on a Cyclically Adjusted P/E ratio basis. There are many caveats, but it is safe to conclude that as yields rise stocks will be incrementally adjusting (and vice-versa).
- If a stock market correction were to occur, it would prompt the Fed to pause along its path. How long the Fed chooses to pause will be determined by the magnitude of the decline in stocks, and whether it spills over to other sectors of the economy.
- A mild correction is unlikely to faze the Fed and there is a notion that the ‘Powell Put’ for stocks has a lower strike than under Yellen or Greenspan, particularly given how easy financial conditions are and how strong growth is. It is also because of inherent strength in the US economy that we think it is too early to call an equity market correction. A sharper correction (closer to -20%) would be different. The Fed would need to evaluate what the economic implications are from the financial channels, and whether the equity market is actually signalling something more sinister on the horizon rather than being about valuations (especially so given the Fed is closer to neutral than before; neutral being seen at 2.50-3.00%).
- The AUD/USD opens this week just above 0.71, it’s “climb back” to that level as much a reflection is just how short speculative positioning in the AUD and NZD are currently, shorts in the NZD at record extremes, the AUD now not too far behind. The market is very long US dollars. US bond yields closed marginally higher on Friday.
- If the AUD/USD presently is more sensitive to good news, then Thursday’s Labour Force report for September could be the tonic. NAB looks for a higher-than-consensus 30K gain in employment (consensus 15K) and a decline in the unemployment rate to 5.2%. See our What to Watch for more details or Ask the Economists. Wednesday’s speech from RBA Deputy Governor Debelle on the labour market will also be closely watched along with tomorrow’s RBA Board Minutes.
- Offshore, the US earnings season gets underway in earnest, valuations already lofty and with the attractiveness of current earnings yields being tested by the increase in US bond yields. China releases its Q3 GDP on Friday along with its September month economic activity reports. GDP is expected to ease from 6.7% to 6.6%. This week is also potentially shaping up as “make or break” week for PM with as yet no deal –especially on the Irish border question – in the lead up to an EU Summit on Thursday.
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