The equity rally that began in 2009 has pushed valuations higher, but has received little support from earnings. Indeed, as Morgan Stanley notes, since June 2012 the equity market rally was entirely driven by valuation and not earnings.
[4]
While there have been cases when better economic conditions pushed up earnings, providing equity market support...,
[5]
there have also been occasions when valuation driven equity market rallies translated into weakness, as witnessed in October 1987.
[6]
The equity market rally which began in 1986 and peaked in the summer of 1987 falls into this category.
Via Morgan Stanley,
In 1986/87, the Fed was tightening, but this is not what derailed the equity market. Instead, it was the Bundesbank sending an unexpected tightening signal via its repo operations that pushed markets over the cliff.
After years of Fed balance sheet expansion, monetary policy will transition away from this, eventually leading to tighter monetary conditions. During this shift, markets are more vulnerable than they have been over the past few years of almost unconditional easing.
The appointment of a Fed President with a hawkish reputation, slower than projected EM growth or EMU’s debt crisis erupting again, lead the list of potential bearish risk events.