Interest rates have been in a freefall for the better part of the past two decades. Moreover, the yield on the 10-year US Treasury, which is the flagship interest rate benchmark, has mostly been below 2% since the beginning of 2012. The 10-year Treasury note did reach 3% by the end of 2013 but has promptly fallen ever since to its current level of 1.59 percent.
In contrast, the stock market as measured by the S&P 500 hovers at an all-time high. Moreover, after the stock market bottomed in February 2009 as a result of the Great Recession, stock market investors have enjoyed a strong bull market that is now almost halfway into its 8th year running. Interestingly, as it relates to the thesis of this article, the stock market had one of its best performances in 2013 in spite of the 10-year Treasury note rising from 1.78% to 3.04% by the end of the year. To be clear, in direct conflict with conventional wisdom, both the stock market and interest rates rose dramatically in 2013.
Conventional wisdom has historically suggested that there exists an inverse relationship between interest rates and stock valuations. The logic goes something like this. When interest rates fall, fixed income investments become less competitive because of their lower yields, and therefore, stocks become more attractive as a result. Conversely, when interest rates rise, fixed income investments become more competitive because of their higher yields, and therefore, stocks become less attractive as a result.
Personally, I’ve always considered this argument to be rational, even logical and sound. It seems to make good sense, because prudent and logically-thinking investors should always be asking a rational question before investing in a stock. Could I get a safer and better return if I invested in something else? Since the 10-year Treasury note is considered one of the safest investments of all, it makes further sense to compare your return expectations on a stock with the theoretically risk-free return of the 10-year Treasury note.
In Wall Street parlance this is often referred to as the “risk premium,” also known as the “equity risk premium.” Since investing in a stock involves greater risk, you should logically expect to earn a higher rate of return when investing in it. In other words, it is only rational to expect a higher rate of return that compensates you for the risk you are taking. Consequently, fixed income truly does become more competitive when interest rates are higher.
However, as logical as this is, it is only truly relevant when both markets are behaving within normal ranges. In economics the qualifying Latin term is “ceteris paribus” which loosely translates as all other things remaining equal or remaining the same. Unfortunately, the real world is often not so accommodating. All things do not remain equal or the same, therefore, other exogenous variables or factors can - and will - often come into play. As a result, the logical model between interest rates and stock values described above doesn’t always work out as expected. Interestingly, this exception to the rule has been the norm for most of the past couple of decades - as this article will illustrate.
Interest Rates and Stock Values Since 1997
As previously stated, I have always considered the theoretical inverse relationship between stock values and interest rates as being a logical assumption. Consequently, I even developed a graph as a component of the F.A.S.T. Graphs™ research tool that measured a stock’s P/E ratio in relation to the interest rate of a 10-year Treasury note. When I first developed this graph, I expected to see this inverse relationship neatly at work. When interest rates were falling, I expected to see P/E ratios moving in the opposite direction - and vice versa.
When I initially entered the industry in 1970, the inverse relationship between interest rates and the P/E ratio of the stock market worked perfectly up until approximately calendar year 2000. Later I will provide a graphic illustrating how perfectly the P/E ratio versus interest rate inverse relationship worked for much of my career. However, since calendar year 2000, both interest rates and the P/E ratio of the S&P 500 moved in lockstep with each other. Interest rates continued to fall and the P/E ratio of the S&P 500 also fell in the face of lower interest rates.
The following “PE Interest Rates” correlated graph clearly illustrates this fact. The dark blue line plots the year-end P/E ratio of the S&P 500 each year and the red line plots the interest rate of the 10-year Treasury bond. Clearly we see both falling in almost perfect lockstep with each other. This is a direct contradiction of what I expected based on the logic presented previously. Consequently, this raises the question: what could have caused both P/E ratios and interest rates to move in tandem since 2000?
The answer becomes clear when you evaluate the level of the market’s (the S&P 500) valuation in calendar year 2000. At the beginning of 2000, the P/E ratio of the S&P 500 was 28.8, which is approximately double a more normal P/E ratio of 14 to 16. Consequently, this aberrantly high valuation for the S&P 500 was a headwind that even falling interest rates could not overcome. The P/E ratio of the S&P 500 had nowhere to go but down from these lofty heights. This is a classic example of one of the exogenous factors I referenced above. Simply stated, falling interest rates did not have the expected effect on stock valuations that logic theoretically dictated.
As indicated earlier, I stated that the inverse relationship between interest rates and stock valuations performed generally as expected for most of my career. The following excerpt of a longer-term graph, which I will present later, illustrates my point. The red line on the graph is interest rates, and the black line is the P/E ratio of the S&P 500. From approximately 1966 to 1982 interest rates fell and the P/E ratio of the S&P 500 rose as the model suggested. All was well with financial logic and modeling.
Then from 1982 to 2000 interest rates advanced strongly, and the P/E ratio of the S&P 500 dropped as a result - and as expected. Once again, all was well with financial logic and modeling. However, since calendar year 2000 the model appears broken. Interest rates continued to drop to record lows, and the P/E ratio of the S&P 500 also dropped along with interest rates. Clearly, during this period of time all things were not equal or the same.
As promised, here is the entire graph illustrating the relationship of the P/E ratio of the S&P 500 to interest rates going back to 1881. What I believe this extremely long-term graph truly tells us is that there is some validity to the notion that P/E ratios and interest rates will move inversely. However, this long-term graph also illustrates that this logical relationship is not perfectly correlated. There are times when other factors will have an impact.