- Fair value of stocks maximizes with 10-year Treasury yield around 4.8%.
- A yield of 2.54% historically came with a stock valuation less than half the current level.
- The 3 months T-bill yield of 0.03% normally comes with stock valuation about 70% lower than current valuation.
- Margin debt contributes to the bubble.
- Valuation by itself gives no clue about near term market direction.
Sometimes I wonder whether the world is being run by smart people who are putting us on, or by imbeciles who really mean it- Mark Twain
I wonder if the people who claim the stock market (NYSEARCA:SPY) is fairly valued or undervalued because interest rates are low have looked at previous times interest rates were this low, or if they have some agenda where claiming it is a fair value is good for them whether true or not. I am curious if they know of some context why it is reasonable for valuation to be high with low interest rates this time, when in the past, such low interest rates corresponded with stock valuations at a fraction of current levels. I don't hear pundits share any context about why this time should be different.
In the last 90 years, stock valuation has a fairly clear relationship with the 10-year Treasury Yield.
Valuation tends to peak with a yield of about 4.8%. Valuation tends to decrease as the yield goes up or down from 4.8%. Each point on the chart represents a month. For example, the lowest point on the chart is for June 1932, and shows the month's average 10-year Treasury yield of 3.53% on the horizontal axis and the 6.9 PEses on the vertical axis.
Here is the same chart, but with the percentage difference between market tops and the best fit red lines.
Here is the data on a time series basis.
The belief that lower interest rates are always good for stock prices is theoretically appealing, but ignores the context that interest rates that are too low correspond with weak economic growth, and at least in the past, lower stock valuations.
Since about 2005, on more days and months than not falling interest rates came with falling stock prices and higher interest rates corresponded with rising stock prices. If you have been watching both the stock market and bond market lately, you have probably noticed that on most days, the 10 year T-Bond yield and stock indexes move the same direction.
The normal calculation of risk premium and the so-called Fed model which use the 10-year T-Bond yield depend on the opposite premise that falling interest rates are good for stock prices. The premise is generally true when the T-Bond yield is above about 4.8%, but is typically wrong when the yield is below 4.8%.
The chart below shows how the correlation between stock price changes and bond yield changes relates to the level of the bond yield. If the black line (correlation coefficient) is above zero, stock prices and interest rates have tended to move in the same direction in the previous 24 months. If the black line is below zero, stocks tend to rise when interest rates fall and vice-versa. The further the black line is from zero, the stronger the positive or negative relationship has been over the previous 24 months.
The red line in the chart above shows the inverted yield of the 10-year T-Bond on a log scale. A statistical calculation of the relationship between the correlation coefficient and the yield suggests a yield of 4.8% is the dividing point between stock and bond prices moving in the same direction or opposite directions.
Since the yield is now about 2.5%, well below 4.8%, the use of risk premium and the Fed model to estimate stock values are probably giving bogus results. The above analysis suggests the S&P500 is about 58% overvalued or more than three times the standard deviation. Even if the economy were strong enough for the Treasury yield to be at the 4.8% optimal the current PEses of 45.2% suggests the market would still be about 14% overvalued.
The PEses is similar to the Shiller CAPE, but uses simple exponential smoothing of real earnings rather than a ten-year moving average.
The PEses has a stronger correlation with the 10-year yield than the CAPE.
The R-squared of the best fit red lines is 0.44 for the CAPE and 0.47 for the PEses. According to the CAPE correlation with the bond yield, the current valuation is further above the historical normal than at 10 of the 12 market peaks since 1925. The exceptions are 2000 and 1929. The point depicted for May 2014 is 42% above the red best fit line or 1.2 standard deviations.
The discrepancy between 3 standard deviations and 1.2 may be partly explained by the 10-year moving average of earnings being farther above exponentially smoothed earnings than ever before. The moving average is a record 80% higher while historically it averages 47% higher. At the 2007 market top the average was 74% higher. At the 2000 top it was 53% higher.
I interpret this record discrepancy to mean the CAPE understates the overvaluation of the stock market. The CAPE has numerous distortions. For example, in the 10 years leading up to the 1929 peak the 10 year average earnings declined 28% due to earnings plummeting after W.W.I. Then as the plummet moved out of the picture, the 10 year average earnings rose 14 percent to the time the stock market bottomed in 1932. This was the exact opposite of the actual changes in earnings during that time. This is why the 1929 high sticks up so much further on the CAPE chart above than on the PEses chart.
Margin Debt Inflates Bubble
High margin debt probably accounts for some of the extremity of recent bubbles. Below are charts of the margin debt and the debt as a percentage of personal income. Using personal income instead of GDP allows looking at data on a monthly basis. The shape of the line using personal income is virtually identical to the one using GDP. You can find the margin debt data here. Monthly data points are released publicly about 5 or 6 weeks after the fact.
(click to enlarge)
There have been three months where NYSE margin debt exceeded 3.17% of personal income: March 2000, July 2007 and February 2014. Each time, margin debt fell the next month. I am not aware of any fundamental reason margin debt has never exceeded 3.3% of personal income, but so far, it has fallen before reaching that level. A March 2014 decline from a February peak may prove to signal the top of a bull market just as declines from the peaks in 2000 and 2007 did. Margin debt has its highest correlation to stock prices on a concurrent basis, but occasionally it leads the market by one to three months as it did in 2007.
Here is a look at the correlation of the PEses with the 10-year yield highlighting the periods when margin debt was above 1.8% of personal income.
Current valuation appears to be inflated by leveraged debt, which will likely prove to be unsustainable. In addition to stock investors at near record debt levels, non-financial corporations are also have record debt levels.
The 10-year yield has a stronger correlation with stock valuation, but it may also be useful to look at the correlation using three-month T-Bill yields.
A T-Bill yield of about 4.2% appears to correspond with the highest stock valuations. Prior to 2009 the current yield of 0.03% corresponded with a PEses of around 14 rather than the current 45.3. This suggests the market could be 70% overvalued.
T-Bond Yield and Monetary Base
Last November, I forecast the T-Bond yield would fall from its then current 2.79%. The call was obviously early, since the yield briefly broke above 3% around the turn of the New Year. The call looks a little better now. The call that stocks would fall was even more premature or will perhaps be proved wrong.
Here is an updated chart from that article showing the correlation between the T-Bond yield and the monetary base as a percent of GDP.
The implication continues to be that the yield will fall and could rival the low yield from 2012.
Stock prices may be vulnerable to a much larger decline than commonly expected. Current low interest rates imply stocks are substantially overvalued perhaps in a bigger bubble than at the peaks in 2000 and 1929. If this is a bubble, it remains unclear what will pop it, or when, or if we are witnessing the beginning of the pop.
The Great Depression was the only other period in the last 90 years where valuation as measured by PEses has been more than 3 standard deviations from the normal relationship with the 10-year Treasury yield. From that low, U.S. stock prices had the best 12 month percentage gain in history. While I don't believe any potential stock decline could rival the decline to that 1932 low, if the economy weakens there probably would be a market crash.
While surveys of economists forecast strength, such surveys also showed strength leading into at least the last 3 recessions that I have watched. March economic data was relatively strong. April data, on the other hand, looks weak so far. Employment for April was mixed. The household employment survey was very weak; 806 thousand people dropped out of the labor force, and the number of jobs declined 73 thousand. Real retail sales declined 0.2%. Industrial production and capacity utilization were both down. Unemployment claims imply strength, but are skewed because a rapidly retiring baby boom lets businesses cut the workforce by attrition without having to fire people.
If the economy were to strengthen enough to move the 10-year yield up to 4.8% the stock decline should be fairly mild. If as I expect the economy weakens and interest rates trend down for several more months the potential for a large and perhaps prolonged market crash rises substantially.
Additional disclosure: There is no guarantee analysis of historical data their trends and correlations enable accurate forecasts. The data presented is from sources believed to be reliable, but its accuracy cannot be guaranteed. Past performance does not indicate future results. This is not a recommendation to buy or sell specific securities. This is not an offer to manage money.