Since the value of a stock today is its future earnings or shareholder dividends discounted back to the present, then price-to-earnings ratios should be in part a function of changes in the interest rate. Looking at the last fifty years of the S&P 500 (NYSEARCA:SPY) index's closing price to its trailing 12-month earnings ratio relative to the prevailing yield on the 10-year U.S. Treasury note produces interesting observations. Examining the linear relationship of the P/E ratio and the 10-year Treasury yield would signal where equity multiples should be in relation to interest rates based on historical trends.
There are many different ways to look at earnings multiples. One can use trailing or estimated forward earnings over various time periods. The popular Shiller Cyclically Adjusted P/E Ratio (CAPE) is based on inflation-adjusted earnings multiples over the past ten years. For purposes of this article, I am using the S&P 500 index price divided by trailing 12-month earnings per share before extraordinary items.
The graph below plots these average monthly P/E ratios versus the average monthly 10-year Treasury yield over the last 50 years. This dataset gives us 600 data points to estimate the relationship between equity multiples and interest rates.
At Friday's close, we sat at a P/E ratio of 21.96x and a 10-year Treasury yield of 2.478%. From the graph above, one can see that we are currently sitting just above the historical trend line. For those scoring at home, the slope of that dotted line is y=-0.9302x + 22.715. The current level of the 10-year Treasury yield would equate to an S&P 500 index level of 20.41x using the historical relationship, which would suggest that the S&P 500 is currently about 7% overvalued.
When I wrote a version of this article in March 2012, the 10-year Treasury yield stood right around 2%, but the S&P 500 P/E ratio was just 14.2x. The relationship suggested that the S&P 500 was nearly 48% undervalued. Over the next 2 years from the publication of that article, the S&P 500 would climb by 42%.
This linear extrapolation of the relationship between interest rates and equity multiples is based on a 50-year dataset that contained very different market environments. The point furthest above the linear trendline occurred in December 1999 when the equity multiple stood at 29.3x and the 10-year Treasury yield of 6.27% would have suggested a multiple closer to 16.9x. That was of course near the height of the tech bubble. From the end of 1999 to the end of 3Q 2002, the S&P 500 would produce a -42% total return.
The point on this gauge that would have signaled the cheapest market conditions occurred in December 1974, when the prevailing 10-year Treasury yield of 7.43% would have suggested a 15.8x multiple, but the market traded at only 7.7x. In that stagflationary environment wrought by the OPEC oil embargo in 1973, both interest rates and equity multiples were too low. Over the next decade, the S&P 500 would produce annual returns of nearly 15%, and the 10-year Treasury yield would crest at 15.8% in September 1981 before it was driven lower by the Volcker-led disinflation.
In the current market environment, we are far from either of these extremes. There are signs that equity multiples are historically elevated. The aforementioned Shiller CAPE is above all previous readings except those preceding the Great Depression and the collapse of the Tech Bubble. My own work on comparing the S&P 500 index level to average hourly earnings suggests the stock market is quite expensive. This comparison of historic equity multiples and rate environments suggests that the market is only modestly overvalued after the recent run-up.
There is a case to be made that in the recent era of ultra-low interest rates, the market simply mis-estimated the correct earnings multiple. It should have been higher over the past several years. Look at all those data points below the trendline and with rates lower than current levels. All of those points occurred over the last several years, and we know that equities ultimately climbed to new records. If the equity multiples in those periods were driven artificially lower by market uncertainty after the Great Recession, then perhaps the trendline should be steeper and the current market multiple would appear less elevated.
The current elevated multiple may be justifiable if you believe that pro-growth policies of the Trump administration will spur further growth. Those sharing that view would suggest that the current elevated P/E ratio relative to its long-term trend is a function of higher expected forward earnings. Conversely, a likely smaller camp could be arguing that the elevated equity multiple is right because the interest rate market has come too far, too fast and rates are going to fall. Our collective jobs as investors is to put today's uncertain market environment into context, and to judge whether the current equity risk premium over interest rates is sufficient. I hope this historical view of earnings multiples and interest rates helps Seeking Alpha readers frame their own view on current equity market valuations.
Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore, inherently subject to numerous risks, uncertainties, and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.
Disclosure: I am/we are long SPY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.