Goldman Sachs: Returns Driven By P/E Multiples, Not Earnings

On Wednesday equity markets launched upward as bond yields fell after the third Q1 2014 esitmate for the GDP number of -2.9 percent clearly signaled an economic contraction. This is not something to ignore and is certainly not something that can be attributed solely to weather. After all these years of blizzards and storms in the northeast, this is the year the consensus decides to blame bad data on weather? Sounds like herd behavior mixed with euphoria and hubris. It's no secret that the Fed has driven this rally through cheap money. It's also no secret the reason unemployment is down is because of an aging population coupled with a decreasing labor force participation rate. This is not an environment that garners legitimate wealth creation through increasing asset valuations and Goldman Sachs GS isn't afraid to show us why.

In a note from June 25, 2014 the investment bank noted that returns, YTD specifically, have been driven by changes in Price/Earnings ratios, not earnings. To repeat, earnings are not driving asset valuations globally YTD (and arguably since the Fed began intervening in markets on an unprecedented scale).

The central bank presence in fixed-income markets has driven nominal 10 year yields to historical lows around the globe.  This cheap paper has driven record breaking Merger & Aquisition acitivity and also made brokerage lending to clients appealing, hence the record levels in Margin Credit we've seen for many months.  Even as we continue to march upward and onward in equity markets, Goldman believes that the lower rates signal the potential for investors and traders to extrapolate equity risk for a just a little while longer.

Going through the verbage used by Goldman YTD in the Goldman Leading Indicator notes shows the changing sentiment on the street as euphoria trumps rationality leaving many partipants ignoring the weak underlying structure of this economy to focus on how much time remains to extrapolate return from equities.  As we approach the time period for the Fed to raise the Federal Funds Rate, those who remain to chase equity returns may find themselves unable to avoid the period when the market begins to price in a hike in rates.