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Why Bonds May No Longer Be Able to Save Stocks

PART:
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Part 2
Why Bonds May No Longer Be Able to Save Stocks PART 2 OF 3

How Long Will US Stock Valuations Hold?

A nuanced stock-bond relationship

Historically, stocks do tend to trade at higher valuations when bond yields are lower. Since 1962 the yield on the U.S. 10-year Treasury note has explained roughly 25% to 30% of the variation in U.S. large cap equity multiples, as measured using the trailing price-to-earnings (P/E) ratio in the chart below. The challenge for investors today is that the relationship is not linear; in other words, the relationship differs depending on the level of rates. Lower rates do indeed lead to higher equity multiples, but only up to a point: When yields get very low, as they are today, the relationship breaks down.

In fact, there is some evidence that when yields are at very low levels, investors should be looking for higher real, i.e. after inflation, yields to confirm the equity market advance. Using yields derived from the Treasury Inflation Protected Securities (or TIPS) market over the past 20 years, equity multiples have been positively correlated with real long-term interest rates. For example, multiples were much higher during the boom years of the late 1990s, a period that coincided with strong growth, despite the fact that real yields were 3%-4%, roughly 10 times the post-2008 crisis average.

This nuance in the stock-bond relationship illustrates the problem of relying exclusively on yields to justify stock prices. While lower rates are generally good for stocks, there are other considerations, starting with economic growth and the factors that drive it.

How Long Will US Stock Valuations Hold?

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Market Realist – Stocks rule over bonds

Russ quite appropriately postulates that lower rates can only lead to higher valuations up to a point. Although investors are preferring stocks over safer Treasury bonds (TLT) (TBT), stock valuations haven’t ended up with valuations like the late 1990s. The trailing PE (price-to-earnings) ratio of the S&P 500 (SPY) (IVV) has remained mostly below 20.0x since 2010 and has stabilized at 25.0x since September 2016.

The forward PE multiple of the S&P 500 has remained at 18.0x since the second week of July 2016. Equity risk premium is increasing with the decrease in bond yields. But how long this will continue is debatable considering sluggish corporate profits. The Federal Reserve has hinted at a potential increase in interest rates in December 2016. There’s also a lot to look forward to from the Brexit, the inflation rate, industrial production, and corporate profit growth.

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