Valuation & Risk On/Off

There must be a huge Risk On/Off track switch out there. Whenever it is flipped on, the S&P 500’s P/E moves higher along with commodity prices and most foreign currencies. When it is in the off position, money stops steaming down the fast track. Instead, it gets diverted into safe assets like the government bonds of the US, Germany, and Sweden. It also tends to jump off commodity currencies and hitch a ride on the US dollar.

The big switch was flipped to the off position following the May 6 French and Greek elections, which could upend all the bailout deal and fiscal pacts worked out by European leaders over the past two years. Such an outcome could push Europe deeper into a recession and weaken global economic activity. In other words, Risk On tends to be associated with widespread confidence in the outlook for global economic growth, while Risk Off indicates widespread fears that the global economy will sputter.

To track the switch from Risk On to Risk Off, we’ve compiled a series of charts in a publication titled S&P 500 P/E & Risk On/Off. So far this year, the S&P 500’s forward P/E peaked at 12.9 during the week of March 18. It was down to 11.9 during the week of May 18. Most of that decline occurred during the first two weeks of May, following the unsettling European election results. However, the sharp drop in the Citigroup Economic Surprise Index has also contributed to the weakness in the P/E.

Prior to the financial crisis that started in 2007, falling bond yields tended to be associated with rising valuation multiples in the stock market. The relationship has been reversed since then. Over the past five years, there has been a very high correlation between the S&P 500’s forward P/E and the 10-year US Treasury bond yield. The valuation multiple is also highly correlated with inflationary expectations embodied in the spread between the nominal and TIPS 10-year yields. There is also a strong correlation between commodity prices and the P/E. A weaker euro and a stronger dollar tend to be associated with lower stock market valuations.

Today's Morning Briefing: Train Spotting. (1) Train wreck spotting in Europe. (2) Happier tracks in the US. (3) Coal loadings are down, while other loadings are mostly up. (4) More autos are riding the rails. (5) Another green light for housing starts. (6) Intermodal loadings on schedule to pick up steam soon. (7) Q1 earnings growth rate was 8.9%, quadrupling expectations. (8) Q2 estimates are going down, setting stage for another up quarter. (9) Lots of NERIs turned positive in May. (10) A Risk On/Off primer. (More for subscribers.)