Low Interest Rates Mean Stocks Are Over-Valued, Not Under-Valued

Sep.20.12 | About: SPDR S&P (SPY)

Have you noticed that, over the last four years, Treasury yields have tended to go up when the stock market goes up? For most of the last 50 years interest rates and stock prices moved in opposite directions. Those who claim that the stock market is cheap because Treasury yields are so low may not have caught on to this change and thus don't realize the market (NYSEARCA:SPY) may be 73% over-valued and headed for a fall.

From 1965 to mid 2008 the 10-year Treasury yielded more than 5.5% and had an inverse correlation with stock market valuation, i.e. higher yields meant lower valuation. However, looking at a broader history the correlation flips to positive when the yield has been below 5.5%. The highest stock market valuation tends to come with a yield of about 5.5%. History suggests the near record low yields should come with near record low valuation. In other words, the risk premium for stocks declines as the 10-year Treasury yield falls toward 5.5%, but then rises as the yield falls below 5.5%. With the 10-year yield down around 1.8% the risk premium should be near an all time high.

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In the scatterplot above, each dot represents a month and shows the month's PEses on the horizontal scale and what the 10-year Treasury yield was on the vertical scale. The current PEses is 37.4. The best fit line (red) suggests a 10-year Treasury yield of 1.78 should have a PEses of 10 - thus suggesting the stock market is 73% over-valued.

For more info on PEse, see here.

If you use Shiller's PE10 the best fit line suggests the PE10 should be at 10 rather than 21.9, representing a 54% over-valuation.

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If you use a standard PE with the last 12 months of available "as reported" earnings, the PE is 16.4 while the best fit line suggests it should be 11 - thus indicating the market is over-valued by a third.

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There is not enough "operating" earnings history to estimate a best fit line.

In the three charts above the more accurate the historical correlation, the greater the suggested over-valuation. The best fit line between the PEses and the 10 year yield has an R-squared of 0.57. The best fit line for the PE10 has a respectable R-squared of 0.46. The R-squared for the PE is a poor 0.08, so the degree of overvaluation is likely closer to the 73%.

Just because the stock market is over-valued does not mean it could not go up and become more over-valued in the next few days or weeks, but it does suggest that the risk is great and the downside dwarfs the upside.

All the pundits I have heard who claim the stock market is dramatically under-valued base the claim on low interest rates. The charts above suggest these claims are a bit like Wylie Coyote running off the cliff, and not falling until he reaches down and finds there is no support. The stock market has run off the cliff and thinks interest rates are right under its feet. Sometime soon it will look down to see they are actually way down in the valley.

Disclosure: There is no guarantee analysis of historical data and trends 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.