Valuations and the Fed Put

 

current stock market valuations, structural change, and the Federal Reserve “cure-all” ...

Shortly after Irving Fisher declared a “permanently high plateau” in 1929, the market fell 89% as liquidity collapsed and the U.S. entered its deepest economic contraction. The Dow’s PE then was about 14; today it’s ~23 versus a long-term average of ~16. But before anyone panics, it’s important to understand what P/E ratios represent.

What exactly is a PE ratio?
The PE ratio price divided by earnings shows how much investors are willing to pay for one dollar of a company’s profits. If a stock trades at $20 and earns $1 per share, its PE is 20, meaning investors are paying “20 times earnings.” A higher PE generally signals optimism about future growth; a lower PE suggests caution. But the number only matters in context: it’s not a risk gauge or market-timing tool, just a snapshot of collective expectations.

A PE reflects market psychology, how optimistic or pessimistic investors feel about the future, it is not the cause of market declines. Comparing today’s multiples to history isn’t a reliable way to predict bear markets, because modern valuations are shaped by forces Fisher never faced: faster, broader information flow that reduces uncertainty, and a Federal Reserve willing to intervene aggressively. Both make investors feel safer taking risk and thus expanding the PE valuation multiples.

Much of today’s high valuations reflects the Fed’s massive liquidity injections. By flooding markets with capital through asset purchases and other interventions, the Fed lowers perceived risk, encourages optimism, and allows PE ratios to stay elevated even before earnings catch up.

Summary:

Valuations are high because investors believe in a better future and the Fed’s willingness to step in, supported by trillions in liquidity over the past decade and a half. PE ratios reflect sentiment and are not the cause of a bear market. Whether today’s valuations are justified will be revealed only through future earnings. They can be deceptive: in May 2009, the PE hit 123.73x due to collapsed earnings, yet it was the best time to buy. Multiples must always be kept in perspective.

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Brett F. Anderson, CFP® CIMA® CAIA® M.S. Econ