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Kensho Stats

If the Fed's right and market valuation needs to come down, it's not necessarily the end of the bull

Federal Reserve Board Chairwoman Janet Yellen
Getty Images
Federal Reserve Board Chairwoman Janet Yellen

The Federal Reserve March meeting minutes indicated central bank officials are worried the stock market's multiple has become a bit too rich.

"Broad U.S. equity price indexes increased over the intermeeting period, and some measures of valuations, such as price-to-earnings ratios, rose further above historical norms," the minutes said. "Some participants viewed equity prices as quite high relative to standard valuation measures."

If the Fed is right and the P/E ratio is in for a contraction, it's doesn't necessarily mean the end of the bull market, or even that stocks will decline, history shows. An analysis using hedge fund analytics tool Kensho found the S&P 500 can still manage to rise during annual periods of multiple compression as earnings (the denominator in the P/E ratio) catch up.

The chart below shows the median return of the S&P 500 during years in the last two decades when the index's trailing P/E declined. The compression happened during nine of those years (2000, 2002, 2004, 2005, 2007, 2008, 2010, 2011 and 2014). We used a median return because the 40 percent loss in 2008 due to the market price plunge after the financial crisis skews the results. Also included in the chart are the four best sector performers during those years, ranked by median return.

The S&P 500 managed to be positive more than 50 percent of the time with a median return of 3 percent during annual periods of multiple contraction. Industries with steady earnings streams performed the best during these type of years.

Earnings for S&P 500 companies are expected to increase by 10.6 percent in 2017, according to analyst estimates collected by S&P Global. If the S&P 500 posts profit growth near that magnitude it could be one of those years where the "E" part of the current hefty 26.6 P/E catches up while prices move sideways to slightly higher.

And the net effect is a lower valuation.

So history shows the Fed can be right about high valuation and it not mean impending doom for markets.

Disclosure: NBCUniversal, parent of CNBC, is a minority investor in Kensho.