Don't Ignore Low Interest Rates

Henry Blodget presented the chart below in one of his posts in Cluster Stock entitled "Stocks Are Overvalued and Tremendously Risky". He states:

We prefer the cyclically adjusted PE ratio popularized by Robert Shiller, which smoothes out the impact of the business cycle.

That said, the cyclically adjusted PE (below) supports the same conclusion: Stocks are about 20% overvalued.

Well he forgot to talk about the other side of the equation which was just under his nose... in fact, it is right in his chart! Interest rates are near the historical lows! This justifies higher P/E ratios so long as the Fed keeps rates at low levels and so long as investors keep buying bonds. I don't buy the argument that bonds are just being artificially supported by the Fed's purchase program. You can see in the data that mutual fund flows have gone to bonds, so there is legitimate demand for that. By the time the Fed decides to raise rates, it will be slowly and the economic recovery would be on firm footing. By this time, the "E" denominator in P/E starts supporting the higher valuations.

While market are in need of a short-term to mid-term consolidation, the facts call for further upside and no pending collapse in stock markets.

Disclosure: None

Comments

[Nick36:]

It all depends on which P/E you choose to use.

The official P/E of S&P 500 is now well over 100.
www2.standardandpoors....

And a P/E of 100 is equivalent to getting paid 0.7% per year on your investment. Which is a lot lower than the current 4.09% you can get by investing in 30-year US Treasury Bonds.

You can argue till you are blue in the face that the earnings of companies are going to improve a lot in the future. But nobody knows the future for sure. And present day facts clearly show that US government bonds are by far a more profitable investment than the current stock market is.

Sep 27 10:19 AM

[Terence Chan:]

Nick, that S&P p/e you are referring too is a trailing p/e. it uses one-off write-offs. it's better to use a 10-year trailing p/e or forward p/e. Also, present day facts are lagging. the market is always forward looking.


On Sep 27 10:19 AM Nick36 wrote:

> It all depends on which P/E you choose to use.
>
> The official P/E of S&P 500 is now well over 100.
> www2.standardandpoors....
>
>
> And a P/E of 100 is equivalent to getting paid 0.7% per year on your
> investment. Which is a lot lower than the current 4.09% you can
> get by investing in 30-year US Treasury Bonds.
>
> You can argue till you are blue in the face that the earnings of
> companies are going to improve a lot in the future. But nobody knows
> the future for sure. And present day facts clearly show that US
> government bonds are by far a more profitable investment than the
> current stock market is.

Sep 27 10:34 AM

[tedstr:]

Right but that PE includes one time charge offs. One of the problems in this recession (and many others) is that earnings enter a "get out of jail free" period. CEOs can write off all their mistakes with impunity which exacerbates the problem. I believe this is where we were in March. This recession is particulalry bad because of the huge bubble in financials.

Sep 27 10:40 AM

[Mad Hedge F...:]

v

Sep 27 11:04 AM

[chap08:]

What matters even more are REAL interest rates. The Fed are looking for low or negative real interest rates. To make that happen, you need some positive level of inflation. This is where Japan struggled. They did have low interest rates, but they always had real interest rates that were inappropriately high, because of deflation.

Sep 27 01:05 PM

[ctjaeger:]

Can't say with any certainty whether we are over or undervalued. It is key, though, to recognize that top line growth simply isn't there. We're seeing profits being maintained by fairly aggressive cost cutting, not by growing revenues. The current market (on forward P/E) would appear to be overvalued given that there isn't much going on in the broader economy to think that revenue will grow in significant fashion for several years. Thus, I would be looking for a small pull-back and basically horizontal pricing for a while. However, you can't deny the momentum.

Didn't we learn our lesson on "alternative valuation" during the tech bubble? At some point, value and fundamentals will matter (at least in my opinion).

Sep 28 09:53 AM

[sethmcs:]

Are real interest rates low? I mean the rates charged to individuals for mortgages, auto loans and credit cards. The spread between what individuals pay and the cost to banks is huge. The banks get to gold and the consumer gets the shaft. Savers and borrowers will pay for the bank's mistakes. With that said I am buying regional bank stocks in Pennsylvania with high yields. The magic of the spread will cover most sins.

Sep 28 12:18 PM

[pslater:]

I suggest you use the BAA bond rate (currently around 5.5% with a 52 week high of 10.2%) to determine P/E ratios as that is the average credit quality of the non-financial companies in the S&P 500. This gives a P/E of about 18 (100/5.5) which is very close to the 19 your chart suggests.

The 20% overvaluation appears to be valid IF you assume that 5.5% is reasonable for the lowest quality of investment grade bonds. The Treasury market is overtly manipulated and IMHO, the biggest bubble in the world. If the BAA rate goes to 6.5% the P/E drops to 15. I'll let you do the math as to what that does for the level of overvaluation.

Sep 30 04:39 PM