How Much Do Interest Rates Affect The Market's Price-To-Earnings Ratio?

by: Sure Dividend

The 10 Year T-Bonds hit all-time yield lows in July of 2016. Interest rates are not just low, they are near all-time lows.

  • Average 10-year T-Bond yield since 1871 is 4.6%
  • Maximum 10-year T-Bond yield since 1871 is 15.3% (September of 1981)
  • Minimum 10-year T-Bond yield since 1871 is 1.49% (July 2016)
  • Current 10-year T-Bond yield is 1.57%

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Source: Multpl

In theory, lower interest rates cause asset prices (including stock prices) to rise. Here's how:

Imagine a stock yields 4% and T-Bonds yield 8%. If T-Bond yields drop to 4%, the stock's yield will look comparatively attractive. Investors will pile on and bid up the share price, reducing the stock's yield back to equilibrium with the T-Bond yield.

If theory holds true, it stands to reason that the S&P 500 will have a higher price-to-earnings multiple on average when interest rates are lower.

But how much higher should the price-to-earnings ratio be? Is the market really overvalued given today's ultra-low interest rate environment?

This article takes a look at the relationship between interest rates and price-to-earnings ratios to determine if the market is truly overvalued on a historical basis today taking into account interest rates.

Who Controls Interest Rates

Before going further, it is important to note that interest rates are not dictated by the free market. If they were, there'd be no need to study their relationship with price-to-earnings ratios as they would always move in or near equilibrium, thanks to market forces.

Instead, interest rates are controlled by the Federal Reserve. The Federal Reserve's primary tool in setting interest rates is controlling the Federal Funds Rate.

The Federal Funds Rate is the rate at which banks lend funds held at the Federal Reserve to each other on a short-term (overnight) basis. The Federal Funds rates indirectly determines borrowing rates for the entire United States economy.

We will explore the correlation of the stock market's price-to-earnings multiple with 10-Year T-Bond yields in the modern financial era; since the United States abandoned the gold standard in 1971.

Correlation Between Market Valuation & Interest Rates

From 1971 through 2015, the S&P 500's price-to-earnings ratio and PE10 has been highly correlated with the 10-year T-Bond rate.

  • PE10 and 10-Year T-Bond correlation of -0.63
  • P/E and 10-Year T-Bond correlation of -0.52

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Source: Data from Multpl

Note: The PE10 ratio or "Shiller PE ratio" divides the current price by average earnings over the last decade. This "smooths out" the price-to-earnings ratio and is a better gauge of valuation during recessions. As an example, the S&P 500's P/E ratio in 2009 was 70.9, which would be wildly overvalued. In reality, earnings were depressed causing a high P/E ratio even though market sentiment was negative. The PE10 ratio was at 15.2 in 2009, well under its mark of 24.0 the year earlier, accurately showing the better valuations during the depths of the Great Recession. This article uses both P/E and PE10 ratios for thoroughness.

There is a clear inverse relationship between the market's valuation multiple and interest rates. The higher interest rates go, the lower the S&P 500's valuation multiple, all other things being equal.

What's a Fair Valuation Today?

What is a fair price-to-earnings ratio for the S&P 500 today given ultra-low interest rates?

Running a linear regression on the data above gives the following:

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Using the slope and intercept above combined with the current 10-Year T-Bond yield of 1.57%, we get the following:

  • Fair price-to-earnings ratio of 28.4
  • Current price-to-earnings ratio of 25.1

Using PE10 tells a similar story:

  • Fair PE10 ratio of 28.9
  • Current PE10 ratio of 27.0

Factoring in near all-time high interest rates, the market is trading around fair value today. One could argue it is actually slightly undervalued!

When Will Interest Rates Rise?

Interest rates have been in free fall since 1982. This has created tremendous wealth in the stock market and real estate market due to rising valuation. This trend cannot and will not continue. Interest rates simply do not have much room left to fall. Interest rates cannot go much below 0.

Here's why. The more banks charge customers to hold cash (which is what negative interest rates imply), the less customers will hold cash in banks. This reduces the banks' ability to loan out money. Moving interest rates to near 0 levels is about the maximum you can stimulate an economy.

If interest rates can't fall, there's only two other options. They can stay around their current levels, or they can rise. Obviously, rising rates will cause most assets to decline in value as their valuation multiples shrink. On the other hand, some financial companies will likely benefit from rising rates.

The global economy is struggling. It is certainly not in rapid growth mode. You don't have to do much searching to get the overall mood and consensus. The following headlines are from the 1st page of a Google News search for "Global Economy," which should be a neutral term:

The general consensus is that the global economy is relatively weak but not in a recession. This is hardly the environment one would expect for any type of meaningful interest rate increases.

There is absolutely no reason to think that the Federal Reserve will sharply increase interest rates. This is especially true when one observes its actions over the last 30+ years. The Federal Reserve has continuously worked to keep interest rates low to stimulate growth.

I doubt the Federal Reserve reverses course and jacks interest rates significantly higher. Doing so would likely throw the United States (and the world) into another recession.

Final Thoughts

Is the market overvalued based on an absolute historical basis? Absolutely. Is the market overvalued given current ultra-low interest rates? No. It is trading around fair value, and possibly a bit lower.

Will interest rates rise soon? No one knows the future. With that said, it appears unlikely given the Federal Reserve's moves over the last 30 years that interest rates will rise in the next several years.

The one exception to this would be if high inflation were to take hold. In this case, the Federal Reserve would likely raise interest rates to curb serious inflation.

The conclusion I draw from this data is that the stock market is trading around fair value given our current artificially low interest rate environment, and that the artificially low interest rate environment will likely be with us for a long time.

Regardless, the prerogative for long-term buy and hold investors does not change: Invest in high quality dividend growth stocks with strong competitive advantages trading at fair or better prices. When the market trades for a lower price-to-earnings ratio, this is easier, but it is still possible today.