By Gary Black
When interest rates rise, it's not necessarily bad for stocks, since a rising rate environment is usually consistent with better economic growth and in turn, better corporate earnings growth. Simplistically, if the rise in rates is offset by the same increase in corporate earnings growth, multiples on stocks shouldn't fall:
Theoretical S&P 500 Index Multiple = 1 / (ke - g)
ke = equity return required by the market, equal to the risk-free rate plus the equity risk premium required to hold equities versus bonds
g = the long-term growth rate of S&P 500 earnings
Looking back over the past 60 years, S&P 500 earnings yields (1 / P/E) have typically traded at a +130 basis-point premium to 10-year Treasury rates. Looking forward, the current spread between the 2016 S&P 500 earnings yield and the 10-year Treasury rate is roughly +380 basis points (2016 EPS is forecasted at $130, 2016 P/E = 16.2x, 2016 E/P = 6.1% versus 10-year Treasury yields of 2.3% today). So if history repeats, 10-year Treasury yields would have to rise to at least 4.8% before we start worrying that stocks are too expensive relative to Treasury bonds, using 2016 earnings as the relevant earnings metric (see Figure 1).
Figure 1. S&P 500 Differential of Trailing Earnings Yields and 10-Yr Treasury Bond Yields
1950 through March 2015
Source: Standard & Poor's, Corporate Reports, Empirical Research Partners Analysis Recessions Indicated by shaded areas.
That said, if recession risks increase, our 2016 EPS forecast of $130 for S&P 500 earnings would come down, and stocks would look more expensive. We currently believe the odds of a U.S. recession are low, given strong recent job growth, manufacturing activity, consumer confidence, and a still highly accommodative Fed.
Long-Tailed Growth Stocks Could Face Multiple Compression
When the market discounts higher interest rates, what has tended to happen in the short term is that longer-tailed, higher P/E growth stocks tend to face multiple compression versus non-growth stocks. This makes sense intuitively, since for a given long-term earnings growth differential between two companies, one a high-growth name and the other a slower-growth name, the relative multiple between the two will compress for a given rise in interest rates, assuming no change in the underlying growth rates of the two companies as interest rates rise. As long-term interest rates increase, this growth differential is worth less (the relative P/E compresses). When interest rates fall, the growth differential is worth more (the relative P/E expands).
As the market starts to discount higher long-term interest rates and as global interest rates start to move higher driven by the long-awaited rebound in economic activity in Europe and Japan, we would expect relative multiples of long-tailed growth stocks selling at high multiples to come in a bit. Even so, we continue to believe we are in a growth regime similar to 1995-1999 and 2004-2007, where growth stocks should significantly outperform value stocks, given valuation spreads between growth and value stocks remain very narrow by historical standards (see Figure 2).
Figure 2. The Case for Growth: Attractive Valuations
1-Year Forward P/E: Russell 1000 Growth Index Relative to Russell 1000 Value Index
December 31, 1989 to March 31, 2015
Source: FactSet (1989-6/2012) and CapIQ (7/2012-present). Past performance is no guarantee of future results.
Our point: one must be careful about what one pays for high-growth, longer-tail names that may be revalued on a relative basis if we get a sustained rise in long-term rates that is not accompanied by a commensurate acceleration in earnings growth.
Past performance is no guarantee of future results. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.
The information in this report should not be considered a recommendation to purchase or sell any particular security. The views and strategies described may not be suitable for all investors.
The price of equity securities may rise or fall because of changes in the broad market or changes in a company's financial condition, sometimes rapidly or unpredictably. Equity securities are subject to "stock market risk" meaning that stock prices in general (or in particular, the prices of the types of securities in which a fund invests) may decline over short or extended periods of time.
The S&P 500 Index is generally considered representative for the market for U.S. large-cap stocks. The Russell 1000® Growth Index measures the performance of the large-cap growth segment of the U.S. stock market, and the Russell 1000® Value Index measures the performance of the large-cap value segment of the U.S. stock market. Indexes are unmanaged, do not include fees or expenses and are not available for direct investment.
Multiple compression refers to when a stock trades at a particular multiple (P/E), and while earnings may be strong, the price doesn't move up and may go down. Therefore, the P/E ratio is reduced even though there has not been deterioration in fundamentals. Price-to-earnings ratio (P/E) is a valuation ratio of a company's current share price compared to its per share earnings. Earnings per share (EPS) is the portion of a company's profit allocated to each share of common stock. Earnings yield is earnings divided by stock price. Long-tail refers to values most furthest dispersed from the mean. Risk-free rate is the theoretical rate of return of an investment with no risk.