The 10 year treasury yield rose roughly 130 bps from its May
low without a material impact on the equity market.
Although there has been a great deal of focus on Fed
tapering and rising interest rates, the S&P 500 remains near
its May high and seems more concerned about politics in
Washington and the outlook for earnings.
Looking at theory:
Given the ability of the S&P 500 to weather the up in
treasury yields, it might be worth reviewing the relationship
between interest rates and equity prices. From a
theoretical standpoint, the value of a stock is based on the
discounted value of earnings or cash flow. As a result, as
interest rates rise the value of a stock should fall and as
interest rates fall the value of a stock should rise, holding
The table following illustrates the impact of interest rates
on the discounted value of $1.00 of earnings. Here is
an explanation of the table:
(click table to enlarge)
The earnings line displays a $1.00 of earnings.
The discount rate represents the interest rate. If you
want, think of this as a 10 year treasury yield or corporate bond
The value is the discounted value of earnings to perpetuity.
The value for the first column is $1.00/1.50% or
The multiple is the discounted value without the dollar
sign. It can be akin to a PE ratio. It is the
multiple that an investors could pay for $1.00 of earnings at a
given interest rate.
The graphic below displays the relationship between interest
rates and the multiple Notice the relationship is
non-linear and the multiple gets exceedingly higher as interest
rates fall and flattens as interest rates rise. At some
point, when interest rates fall sharply, the multiple or
valuation gets hard to embrace.
The chart following displays the relationship between the 10
year treasury yield and the 4-quarter trailing PE ratio for the
S&P 500 based on Generally Accepted Accounting Principles.
Extreme PE ratios over 40 were eliminated and occurred
during the recent Great Recession and 2001 recession time
frames. By excluding these values, it is easier to see the
relationship. Earnings fell off sharply in these periods,
making the PE ratio not very meaningful.
Furthermore, the graphic looks at the relationship since 1970
and separates the PE ratio by 10 year increments. In other
words, the PE ratio 10 year treasury yield relationship was
broken out by the 1970's, 1980's, 1990's, 2000's, and 2010's.
The graphic provides a number of insights.
First, there is a loose relationship over time between the
level of the 10 year treasury yield and the PE ratio on the
S&P 500. Using an exponential fit, the 10
year treasury yield explains about 41% of the movement in the PE
ratio across all periods.
Second, the relationship between the 10 year treasury yield
and the PE ratio shifts over time. It is not stable.
The relationship looks "tightest" in the 1970's and 1980's.
In the 1970's, the 10 year yield explained about 66% of the
movement in the PE ratio, while in the 1980's the 10 year yield
explained 77% of the movement in the PE ratio. The
1990's were less strong with the 10 year explaining 46% of the
movement in the PE ratio.
Third, the current relationship between the 10 year yield and
the PE ratio is weaker than it looks quantifying it
statistically. The 10 year treasury yield has
explained just 16% of the movement in the PE ratio.
Moreover, the relationship seems out of line with the other
Fourth, the curves on the graphic look like demand
curves. In other words, they seem to suggest the
willingness of investors to own equities for a given set of
interest rates. For example, investors were willing
to pay more for equity at a 9% interest rate in the 1980's
compared to the 1970's. Similarly, investors desired to pay
more for a stock in the 1990's compared to the 1970's at a given
10 year yield. The political and geopolitical environments
were friendlier for equities in the 1980's and 1990's relative to
the 1970's. Remember, the 1970's saw two oil price shocks.
The 1990's saw much of the world embrace free markets and
Fifth, the relationship between interest rates and equities
was very variable in the 2000's. The end of the dot.com bubble,
the super cycle in commodities, and the interest in EM investing
may have played a role in confusing the relationship, although a
number of quarters could be lumped together to highlight a
relationship. It almost looks like the demand for equities
was falling for a given interest rate during the period, but the
PE ratio ratios were very distorted by bubble period in the early
The question may come to mind:
Why is the trade not paying more for equities now given
the historically low level of interest rates?
It seems like the PE ratio should be much higher.
It is hard to directly answer this question, but here are a
First, the market is well aware of the Fed Reserve's actions
to provide stimulus and artificially lower interest
rates. The market may see the Fed's actions at
transient and be reluctant to price a high PE ratio. In
other words, the market is actually priced at a much higher rate
Second, investors have been burned by equities twice in the
2000's with the financial crisis in 2008 and the dot.com bubble
around 2000. There has been a major investor shift to bonds
in recent years. Some of this psychology and investor shift
may be showing up in a low PE ratio relative to interest rates.
Demographic factors could also be at work. Baby
boomers have aged and may be more defensive favoring fixed
income, for example.
Third, the graphic displays the relationship between the 10
year treasury yield and the PE ratio, but the 10 year yield may
not be the correct discount rate for equities. The 10 year
treasury is backed by the printing press of the U.S.
government. One could argue the quality of the government
paper given the circus in Washington, but most textbooks view
treasuries as the risk free rate. There is an equity risk
premium which is not displayed in the scatter chart.
There are times when the equity risk premium rises and periods
when it falls. When investors discount earnings to
value a share, the discount rate is based on the risk free rate
plus some risk premium. The equity risk premiums
changes over time. It may be relative high in current
times. Certainly politicians across the Global have not
been able to generate strong economic growth, regulation has been
a burden, and the geopolitical land scape is uneasy. These
factors argue for a high risk premium.
Fourth, since the PE ratio interest rate relationship gets
"silly" at extremely low interest rates, the market may be just
looking more at the average PE ratio to value stocks. The
current PE ratio on a GAAP basis is set to be about 17.8 at the
end of Q3. This is slightly above the longer term average
which is just below 16.0. Going forward, the PE ratio is ripe to
decline below average based on current profit estimates.
Fifth, it is possible that the equity market has "value" and
is pricing caution. This may open the door to higher
returns in the coming years. Put another way, the equity
risk premium could shrink. The scatter seems to suggest the
PE ratio could easily be in the 20's given the current level of
the 10 year treasury yield.
The fixed income market is also pricing more
The spread between the Moody's Baa corporate and the 10 year
treasury was 2.70% a few days back. A Moody's Baa
corporate is neither highly protected nor poorly secured. It is a
median grade corporate note. Going back to 1970 and using monthly
data, the spread has averaged 2.19% with a median of 2.06%.
Like the equity market, the corporate debt market seems to be
cautious about embracing the low yield in the treasury
market. In other words, the risk premium in the
corporate market also seems high compared to average. The
same result is present when using a ratio spread between the Baa
and 10 year treasury in order to adjust for the rate
structure. The ratio spread was 2.02 compared to an average
of 1.43 and a median of 1.30.
One might loosely, off the cuff, draw the conclusion that the
corporate debt market thinks treasury yields are roughly 50 bps
too low. It is fair to think that the spread relationship
would be near average with corporate profits expanding, the
economy growing, and the rate structure low.
Summing it up:
The relationship between the 10 year treasury yield and the PE
ratio on the S&P 500 is unstable overtime. In theory,
investors should pay more for stocks when rates are low and less
for stocks when rates are high. However, the equity risk
premium tends to cloud the relationship between treasury yields
and the PE ratio, and empirically speaking the relationship
between stocks and interest rates is much looser than we would
like to think.
Stocks look cheap compared to the level of the 10 year
treasury. This may be a piece of good news for stock bulls. An up
in interest rates may not have as much of an impact on the
as feared. The outlook for earnings and the environment for
economic growth may be much larger factors in stock market
pricing in the coming months.
SPDR-DJ IND AVG (DIA): ETF Research Reports
ISHARS-7-10YTB (IEF): ETF Research Reports
ISHARS-IBX IG (LQD): ETF Research Reports
SPDR-SP 500 TR (SPY): ETF Research Reports
ISHARS-20+YTB (TLT): ETF Research Reports
To read this article on Zacks.com click here.