So far in 2021 the yield on the benchmark 10-year government bond has surged from 90 basis points to over 150 (hopefully you refinanced your mortgage last year) and higher rates have many investors concerned given the rapid rate of increase. Though the financial markets have become a bit more volatile lately, equities have been range-bound and peak-to-trough losses have not been more than 5 percent at the worst point.
So how much concern should there be about rising rates? Given that equity prices are a function of profits as much as they are about interest rate sensitive metrics like P-E ratios, I think we really need to look at the big picture. In that sense, a 10-year bond yielding 1.5% is pretty tame regardless of where it was a few months ago.
Right now the S&P 500 index trades for about 23 times projected profits for this year. If that metric seems high, it’s because it is. Pre-pandemic the S&P 500 traded for about 20x, the 5-year average multiple was around 19x and the 10-year average was around 17x. If we assume coming out of the pandemic-induced recession that interest rates will normalize and the market reverts to a 19-20x earnings multiple, then we can quickly conclude that stocks might be roughly 15% overvalued at present.
However, the reason why market timers have a bad track record is that there are several different ways that overvaluation could cure itself; a swift double-digit market decline being only one. Coming out of a recession only complicates this because corporate profits are rising again and fiscal stimulus at the governmental level is elevated, which makes the odds of an overshoot on earnings more likely than normal.
Since financial markets are forward looking, investors could very well be looking out to 2022 already, to get an idea of what a normalized profit picture looks like. What if earnings grow by double digits again in 2022? In that case, S&P profits could reach $190 next year, making the current 3,900 level on the S&P 500 look reasonable (the same earnings multiple we saw heading into 2020). While it is hard to see how the market is materially undervalued at present, there is certainly a path for a relatively calm normalization of profits and equity market valuation here in the United States.
While most are focused on interest rates right now, I actually think profits will hold the key over the next 12-24 months. In the 5 years pre-pandemic, when the S&P 500 averaged a 19x trailing P/E ratio, the 10-year bond averaged a mid 2 percent yield. Given the willingness of the Federal Reserve to keep rates low in the absence of inflation, I expect P/E ratios to remain high for the intermediate term. Whether stocks fall a bit, stay stable, or rise a bit, therefore, will depend on the pace of earnings growth.
And given that such a pace is likely to be strong in 2021 and 2022, there is a path for equity market valuations to normalize without a major market drop. Essentially, elevated valuations today can be corrected as long as corporate profits grow faster than stock prices over the next couple of years, which will result in a falling P/E ratio during economic expansion. With rates remaining low, equity investors are likely to accept such an outcome as a base case scenario and continue to allocate funds to stocks.
I would be much more concerned about a larger market decline (i.e. 20% or more) if we see profit growth sputter later this year and into 2022. Without consensus or above earnings, the path to a valuation normalization could become more treacherous.
I will leave you with some charts that show the relationship between rates and equity valuations over the last few economic cycles. I find them interesting because they indicate that recent equity market strength has not been vastly out of line with historical norms when interest rate levels are considered.
Author’s note: The charts below show P/E ratios for the S&P 500 computed using peak historical calendar year earnings, meaning that depressed earnings during recessions are not included. During recessions, earnings fall dramatically which increases P/E ratios and makes the market look more expensive even though stock prices have fallen. By using the previous cycle’s peak earnings instead, P/E ratios drop during periods of stock market weakness, which better denote the cheapness of stocks after large declines (see the 2008 period in the first chart as an example).
First, we have a chart showing the spread between the S&P 500 P/E ratio and the 10-year bond yield, which shows the large increase in stock market valuation during the late 1990’s dot-com bubble, as well as a return to high valuations in recent years.
While the last chart might make stock investors queasy, consider what it looks like when we add the absolute level of interest rates to the data. With rates falling generally over that period, rising valuations don’t seem as concerning.
The final chart below takes the one above and add linear trend lines for both datasets to show the long-term trend. Considering the slope of each trend line and what we would expect the relationship between interest rates and P/E ratios to be, the market’s pricing over time seems to have been quite rational (as rates drop, valuations increase, and in a relatively correlated fashion).
