Is the current high valuation of the market a dangerous aberration from the norm? Many analysts contend the market isn’t overvalued, because there is a causal connection between low interest rates and high earnings multiples.
The theory is that if you make money cheap companies cannot help but invest and grow their earnings. How does their theory hold up to scrutiny?
Let’s review the facts.
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S&P 500 well above P/E multiples
Using trailing 12 month earnings, the current P/E of the S&P 500 is 22.3. This is far higher than the 15.7 average P/E measured since 1871. This historical data appears to be inconsistent with the low interest rate, high earnings multiple theory.
Fed model hypothesis
This theory holds that the stock market, at any given point in time is undervalued whenever the earnings yield on equities, which is the inverse of the P/E ratio, is higher than the yield on the 10-year Treasury bond, which is used as a gauge of investors’ expectations for long-term inflation.
Data over the past 150 years, however, reveals that the earnings yield by itself is a more accurate predictor of the stock market’s future return than earnings yields adjusted by the prevailing 10-year Treasury yield. This data shows there is little historical support for the predictive power of the Fed model.
Sophisticated models have challenged the theory
A statistical measure that tests how one data series affects another was applied to the Fed model theory, to test how effective low interest rates were for predicting subsequent market valuations. The results showed a rather low correlation between low rates and historically high P/E multiples.
Food for thought
How do proponents of the Fed model explain undervalued European equities? Europe has had negative interest rates for almost a decade. According to the low rate/high valuation theory, European stocks should be selling well above their average historical P/E multiples. But the fact is they have been undervalued relative to the U.S. market for almost a decade.
Because there is no guarantee that interest rates will continue to remain historically low, should the Federal Reserve raise rates in the near future the Fed model theory will be put to the test.
This article originally appeared in Real Daily