Low and negative interest rates have been a big factor in the magnitude and duration of the current bull market. As central banks yanked risk-free interest income from the world’s responsible savers and retired investors, many have been pushed (kicking and screaming if they are smart) into riskier assets.
After years of getting bludgeoned by zero percent interest rates, the accepted wisdom on Wall Street now seems to be that as long as interest rates are held in the tank, the stock market will continue to float higher and higher. Stocks may be at one of their most expensive levels on record, but relative to negative yielding bonds they are still cheap.
Russ Koesterich, writing in Barron’s (subscription required) gives cause for caution on this theory.
A nuanced stock-bond relationship
Historically, stocks do tend to trade at higher valuations when bond yields are lower. Since 1962 the yield on the U.S. 10-year Treasury note has explained roughly 25% to 30% of the variation in U.S. large-cap equity multiples, as measured using the trailing price-to-earnings (P/E) ratio. The challenge for investors today is that the relationship is not linear; in other words, the relationship differs depending on the level of rates. Lower rates do indeed lead to higher equity multiples, but only up to a point: When yields get very low, as they are today, the relationship breaks down.
In fact, there is some evidence that when yields are at very low levels, investors should be looking for higher real, i.e. after inflation, yields to confirm the equity market advance. Using yields derived from the Treasury Inflation Protected Securities (TIPS) market over the past 20 years, equity multiples have been positively correlated with real long-term interest rates. For example, multiples were much higher during the boom years of the late 1990s, a period that coincided with strong growth, despite the fact that real yields were 3%-4%, roughly 10 times the post-2008 crisis average.
This nuance in the stock-bond relationship illustrates the problem of relying exclusively on yields to justify stock prices. While lower rates are generally good for stocks, there are other considerations, starting with economic growth and the factors that drive it.
Jeremy Jones, CFA
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