By: Lyn Alden
In November so far, the C Fund is up 1.2%, the S Fund is up 1.6%, and the I Fund is up 1.2%. The G Fund and F Fund are both up a small fraction of a percent.
The S&P 500 has crossed 2,600 for the first time, hitting a new record. But its cyclically-adjusted price-to-earnings (CAPE) ratio sits at 31.5, the highest valuation it has ever been relative to stable earnings, except for at the peak of the Dotcom Bubble. Here’s the updated CAPE chart:
At the beginning of this month, President Trump nominated Jerome Powell to replace Janet Yellen as the Chair of the Federal Reserve. The confirmation hearing is on November 28, and if confirmed he would begin serving in the position in February.
Powell is widely viewed as a “safe” choice, meaning one that would not shake up current market perceptions of monetary policy moving forward. Changing interest rates by the Federal Reserve have a big impact on both corporate bonds and corporate stocks, as well as consumer finance such as mortgages and other types of debt. Powell already serves on the board of the Federal Reserve and is considered neutral, neither particularly hawkish (prioritizing low inflation and potentially higher interest rates) or particularly dovish (prioritizing low unemployment and leaning towards lower interest rates), and is expected to continue Yellen’s current policy of gradually raising interest rates.
Here’s the chart of the effective federal funds interest rate over the past six decades:
This recent low interest rate environment has been good for consumers and most businesses.
Consumers save money on mortgages, student loan payments, auto loans, credit card debt, and personal loans, which gives them more spending power. Businesses have lower costs of borrowing as well, which allows them to expand more quickly or buy back large numbers of shares to boost earnings per share.
On the other hand, with such low rates bank savings accounts don’t even keep up with inflation, and banks generally have smaller margins between their borrowing and lending rates, meaning less profitability. Bonds also provide less income, barely keeping up with inflation. This leads a lot of people to move into stocks instead, for better returns. But this can lead to overvaluation in stocks.
One of the key risks of holding interest rates this low for this long is that such expansionary policies could trigger inflation. However, so far that has not materialized during this business cycle at all- inflation has remained very low despite the Federal Reserve maintaining persistently low interest rates. The Federal Reserve targets an inflation rate of 2%, and it has been mostly at or below that number in recent years.
As you can see from both charts, high interest rates tend to correlate with low stock valuations. The very high inflation and interest rates in the late 70’s and early 80’s was also the time when the S&P 500 CAPE ratio was unusually low. And now in this past decade when interest rates have been at record lows, stock valuations have inched back up to unusual highs.
Investors are paying attention to this changing of the guard at the Federal Reserve, because Powell’s views on monetary policy, unwinding the Fed balance sheet, and what he would do during a recession are all factors that can affect market performance in years ahead.