You’ve heard the story before:
Equity valuations are high…
Therefore, high valuations are “justified” by lower interest rates.
Why?
Some say it’s because stocks are simply the present value of their future cash flows. And lower interest rates (r) in the denominator of that equation should result in a higher present value, and vice versa.
Others argue that when bond yields are lower, earnings yields (Earnings/Price) should be lower as well. That’s because investors are said to be choosing between stocks and bonds (they are “competing” asset classes), and if they are accepting a lower interest rate on bonds, they will also accept a lower earnings yield on stocks.
The inverse: they will accept a higher valuation (Price/Earnings).
Putting aside whether these theories hold water, what does the actual data suggest?
Is there a strong relationship between interest rates and valuations? Let’s take a look…
With data going back to 1881, the r-squared between the two variables (CAPE Ratio and 10-Year Treasury Yield) is .06, which means that knowledge of interest rates accounts for only 6% of the variation in CAPE ratios. This would be essentially useless for predictive purposes, as 94% of the variation in CAPE ratios occurs for reasons unconnected to interest rates.
Breaking 10-year yields down into deciles, one can readily observe the lack of a linear relationship…
The lowest decile of interest rates (0.6% – 2.4%) has a median CAPE Ratio of 21.1, which is not materially higher than the median for all deciles (20.4). Additionally, looking at the minimum CAPE ratios in bottom 2 interest rate deciles (11.7 and 10.9) indicates that there have been times where valuations have been low along with rates.
If low interest rates were the primary driver of higher valuations, we should see the highest valuations in the lowest interest rate periods.
But this is not the case. Instead we find the highest average CAPE ratios in the 8th decile of interest rates (range of 4.5% to 6% 10-Year Treasury yield). This occurred during the dot-com bubble in the late 1990s and early 2000s.
But what about the story of the early 1980s, the one where interest rates started at record highs and were accompanied by extremely low valuations? Yes, this is a good one, and over the next 18 years stock prices and valuations would rise while interest rates would fall.
The only problem is this story is never followed by the prequal, the period from 1949 to 1968 when valuations and interest rates moved higher, together.
The full data set shows a correlation of -0.24, meaning that there is a slight historical tendency for lower interest rates to be associated with higher valuations (and vice verse). But it’s not nearly as predictive as many suggest.
There have been a number of periods where interest rates and valuations have been low (1934-35, 1938, 1940-1954) and other periods where interest rates and valuations have been high (1995-2000). There is no precise formula that can give you the appropriate valuation at a given interest rate.
So why do many still contend that interest rates are the primary driver of equity valuations? Likely because we prefer simple narratives in explaining things, and low interest rates seem to be the perfect rationale.
But even if it were true that the current high valuations were “justified,” the most important questions for investors still need to be asked:
a) Does that mean future returns will be strong?
b) What happens if/when interest rates rise?
Which is to say a justification, even if true, is not predictive; it merely attempts to explain the present. If your entire bullish argument is predicated on low interest rates, that alone is not enough. You will need even lower interest rates (and even higher valuations) in the future to experience above-average returns. And if rates were to rise instead of fall (which would not be an unreasonable expectation as we hit all-time lows last year), your entire argument falls apart.
When it comes to equity markets, nothing is as simple as it seems. The narrative of low interest rates serving as a panacea for extremely high valuations is the latest example.
Related Posts:
What Can You Do About High Valuations?
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