Ultra-Low Interest Rates Indicate U.S. Stocks Are Expensive

Includes: DIA, QQQ, SPY
by: James A. Kostohryz

There are a great many financial pundits that argue that stocks are cheap because the earnings yields on equities are high relative to the very low yields on bonds. I have already addressed one set of reasons why such arguments are flawed.

In this article I will address another set of reasons that should be even more obvious to investors. Strangely, most investors don't seem to see this, even though it is practically slapping them on the face.

Low Treasury Yields Indicate Low EPS Growth In Future

10Y Treasury yields at unprecedented lows of 1.40% indicate that investors believe that US economic growth in the next decade is likely to be lower than it ever has been over a ten year span.

The Fed clearly agrees with this pessimistic/fearful outlook for the US GDP growth outlook, which is why the FOMC has set Fed Funds rate at record low levels for an unprecedented period of time. Additionally, implicit in the record low interest rates -- set by the Fed and investors -- is an assessment that there is a relatively high risk of sharp and protracted economic recessions during the next decade or more.

In sum, in the current environment, ultra-low interest rates are an indicator of expectations of ultra-low future EPS growth. Therefore, to say that ultra-low interest rates currently provide a formulaic rationale for high and rising equity valuations constitutes an elementary failure of logic.

Low Treasury Yields Indicate Low Returns On Equity

The other message being sent by the Treasury market is that the return on capital for investments (of all types) in the next ten or more years is expected to be historically very low.

Why? There is a competitive market for capital. If returns on equity capital from investments in productive enterprises were projected to be high, Treasury yields would also have to be high to compete for funds (particularly given the US Treasury's enormous financing needs).

As it currently stands, ultra-low Treasury yields are a clear indication that investors as a whole believe that returns on capital across the entire economy (and indeed, the entire world) will be very low and/or risky.

It is logically untenable to formulaically argue that stock valuations should be high due to low bond yields when expected overall returns on capital invested (indicated by those same bond yields) are so extraordinarily low.

QE As A Warning of Low Growth and High Risk

Some investors may argue that Treasury yields are only low because of QE and/or the expectations of QE. They may further argue that "money printing" in the form of QE will drive up stock prices. However, these arguments beg the question: Why is the Fed implementing QE?

When you see a bomb squad trying to diffuse a huge bomb in a building, does that make you want to run in and offer to purchase an apartment there at the price listed in yesterday's newspaper? It is fundamentally illogical to make a case for high equity valuations based on a combination of low interest rates and QE.

First, consider the motive for QE. Is QE not being implemented due to the very real risk that the US economy would collapse if the Fed did not intervene in this fashion? How is that a policy that indicates the presence of a substantial risk of economic collapse becomes an argument to buy stocks? The mere presence of QE is an indicator of extraordinary macroeconomic risk. That sort of macro risk signal, combined with the deflation risk being signaled by ultra-low interest rates, is hardly compatible with a bullish argument for stocks.

Second, what of the argument that the risk of hyperinflation potentially brought about by QE is or should be reflected in stock values? This argument is not available to anybody that argues that stocks are cheap because interest rates are low (which is the argument that this article addresses). It is simply illogical to argue that stocks are or will price in hyperinflation while bonds are simultaneously pricing in deflation. Schizophrenia is a disease, not the basis for an investment strategy.


In sum, in the current macroeconomic environment, it is really quite absurd to cite low Treasury yields as an argument in favor of the notion that stocks are cheap. If anything, the message from the Treasury market is quite the opposite.

First, the message from Treasury yields is that EPS growth derived from US economic growth is likely to be historically poor during the next decade or more. As such US equity P/E multiples should be historically low. Second, the message from Treasury yields is that expected long-term returns on equity capital will probably be exceedingly low. This also implies that P/E multiples should be historically low.

Third, the extent that long-term bond yields are pricing in QE, equity values should be expected to be low in order to reflect the sort of low growth scenario and high levels of macro risk that are giving rise to expectations of QE.

The problem is that US equity valuations are currently not low by historical standards. US equity P/E multiples based on forward EPS are currently roughly in line with historical averages. Furthermore, based on the most popular metrics of normalized EPS such as Robert Shiller's P/E 10, US stocks are actually overvalued.

In sum, there may be many legitimate arguments to buy stocks; the argument that ultra-low interest rates makes stocks cheap is not one of them. In the current environment, characterized by high extraordinarily macro risks and low growth, ultra-low interest rates do not make stocks such as Apple (NASDAQ:AAPL), AT&T (NYSE:T), Cisco (NASDAQ:CSCO) or index ETFs such as (NYSEARCA:SPY), (NYSEARCA:DIA) and (NASDAQ:QQQ) more attractive than they would be in a normal macro environment with higher interest rates. To the contrary, if ultra-low interest rates are transmitting any useful information at all for equity investors, it may very well be that they should be extremely cautious about purchasing stocks.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.