Fed's Underlying Message Could Signal Economic Storm Clouds

The euphoria with which investors in the U.S. 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 that the Standard & Poor's 500 valuation, now at its most expensive on a price-to-earnings basis since 2010, becomes harder to justify.

The Standard & Poor's 500 is up 20 percent so far this year and hit new highs last week, boosting the index's forward p/e 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 2007-2009.

Profit growth for 2013 is expected at about 6 percent, a far cry from the 31 percent 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 current profit expectations fail to materialize, valuations could be stretched.

Markets had expected the Fed last Wednesday to cut back on its $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 in 2013 and 2014.

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 political gridlock in Washington but also because of concerns that prices had got over-extended.

Now, investors' focus in the next few weeks is going to be on both Congress and third-quarter results, both of which will help show whether the Fed's prudence was warranted.

If stocks hold up it may be because of a rally in the bond market since the Fed announcement makes Treasuries less attractive. The 10-year Treasury yield rose to around 3 percent in recent weeks, bringing in asset allocation investors who found that yield more appealing. Now, it is back down to 2.74 percent.

PROFIT CYCLE WELL OFF PEAKS

Growth has slowed substantially since the peaks of this earnings cycle. For the second quarter, earnings increased 4.8 percent, the 15th straight quarter of S&P 500 profit growth.

The S&P 500's big gains in 2013 have caused the forward price-to-earnings ratio to rise to 14.94 from 12.7 at the end of 2012. Multiple expansion has come as investors bet on improved growth that would in turn allow the Fed to reduce its extraordinary support for the U.S. economy.

That ratio is about the same as the 14.8 level it was at the start of 2010, when year-over-year profit growth was much higher.

While that's not considered expensive by historical standards - the average forward p/e is estimated at about 17 by S&P - it does fuel concerns about valuations. Earnings growth is now expected at 6.3 percent for 2013, and estimates for the year have fallen about one percentage point in the past 90 days, according to Thomson Reuters StarMine data. The concern is that earnings growth will continue to slip as the economy's path remains mediocre.

"If the Fed needs to continue to keep their foot on the gas pedal, it implies that we're not gaining the momentum that current stock prices have priced into their valuations," said Rick Meckler, president of investment firm LibertyView Capital Management in Jersey City, New Jersey.

The sunny outlook has also meant that the best performing stocks have been growth-oriented names. After a weak August, companies with already high p/e ratios and high short interest rebounded, and have outperformed for the balance of the year.

Netflix, the S&P's best performer with a 239 percent gain for the year so far, has a very high forward p/e ratio of about 106, according to Reuters data. Electric car maker Tesla, up more than 400 percent for the year so far and a long-time favorite of short-sellers, is trading at about 112 times earnings forecasts.

In a sign of how frothy the market may have become, shares of cybersecurity company FireEye Inc and digital advertising company Rocket Fuel Inc, soared on their stock trading debuts on Friday, both more than doubling in price at one stage.

"There's not a lot of room for error," Meckler said.

Companies have also become less able to rely on cost cutting to boost their bottom lines, with sales growth anemic. Year-over-year revenue growth has ranged from a decline of 0.8 percent to a gain of 3.6 percent over the past four quarters, according to Thomson Reuters data.

Third-quarter earnings are expected to have increased 4.8 percent, while fourth-quarter growth is estimated at 11.1 percent, according to Thomson Reuters data. But such estimates can be quickly pared back - third-quarter growth was estimated at 8.5 percent on July 1, less than three months ago.

If earnings estimates continue to fall, that's going to raise the market's p/e, or force investors to pull stocks lower in response to what they see as overinflated valuations.

"Either the continued policies will lead to an actual pickup in growth which would justify these prices, or I think the market will begin to come down from these levels," Meckler said.

(Reporting by Caroline Valetkevitch; Editing by Martin Howell and James Dalgleish)