Do today’s minuscule rates of interest justify stock markets’ sky-high valuations? Bulls often imply – and sometimes boldly assert – that they do, and mainstream theory is on their side. The problem is that theory is elegant and tidy, whereas reality is clumsy and messy: many factors, many of them fleeting and some of which counteract others, are at play. In Australia and the U.S., the evidence is underwhelming: since the 1970s, long-term rates have been one of the factors that have influenced valuations. But they’re hardly the only one – and arguably aren’t the most important; and in the U.S. from the 1880s to the 1970s, they were inconsequential. The implication is clear – and, for bulls, unsettling: if you believe that artificially low rates justify today’s high valuations, then your confidence in central banks is misplaced.
Low Rates Underpin Bulls’ Confidence
In the first article of this four-part series, I showed Why This Market Is 33-50% Overvalued. Specifically, (1) its earnings have long been stagnating and during the next couple of years are likely to fall further, and (2) its PE ratio is inflated. During the current bull market (the All Ordinaries Index’s rise of 20%, from 4,564 on 9 March to 5,477 on 14 April, was its fastest-ever; and its continued increase to 6,000 on 27 May ranked among the quickest), these two contentions will convince few bulls. In response, they typically say something like “never mind stagnating earnings: thanks to central banks, rates of interest are microscopic – and these puny rates amply justify the high PEs which buoy markets.”
It’s easy to rebut this criticism. But let’s first acknowledge a key point: theoretically, a stock’s value equals the net present value of its future cash flows. Lower discount rates thereby boost stocks’ prices. Do long-term rates of interest (such as 10-year Treasury bonds’ yields) proxy discount rates? If so, then lower yields beget higher valuations, and vice versa.
Culture and History versus Economy and Finance
This conjecture hails from academia. In the real world, do rates determine valuations? Data compiled by Robert Shiller (Leithner & Company has analysed them, and his Cyclically-Adjusted PE Ratio (CAPE), repeatedly over the years) are unequivocal: since 1881 the relationship has been so weak that it’s statistically and substantively insignificant (Figure 1). At the average long-term rate (4.5%), CAPE has varied greatly – between a minimum of 5 and a maximum above 30; and at the average CAPE (17), long-term rates have also varied very widely – between a low of 2% and a maximum of 9%. What the plot doesn’t show, since it doesn’t display these data temporally, is that during two intervals (the early-1920s was the first; the early-1930s to mid-1960s was the second) rates and valuations were low; in another (1995-2003), both were elevated. It’s telling, and should give bulls pause: the years since the Global Financial Crisis provide the only instance when very low rates and sky-high valuations have coincided.
Figure 1: Shiller’s CAPE (Vertical Axis) and Long-Term Rates of Interest (Horizontal Axis), U.S., 1881-2020
Shiller’s CAPE is the ratio of price (monthly observations of the S&P 500 Index) divided by the moving average of ten years of its adjusted (by the Consumer Price Index) earnings. What about the simple PE – that is, the ratio of the Index to its earnings? Figure 2 plots the results. They don’t help the bulls’ case: the relationship is even weaker (R2 = 0.01) than the one using Shiller’s CAPE (R2 = 0.03)
Figure 2: S&P 500 Index’s PE and Long-Term Rates of Interest, U.S., 1881-2020
What explains the absence of a significant relationship between rates and valuations in the U.S. since the 1880s? The answer, I suspect, is cultural and historical rather than economic or financial: once upon a time, investors’ long remembered past losses and intensely feared future hammerings. The Depression of 1920-1921 was among the 20th century’s worst; the Great Depression of the 1930s was also very bad and lasted much longer. At the end of the Second World War, investors remembered what had occurred after the Great War and throughout most of the 1930s – and dreaded a repetition. Fearing another collapse of stocks, market participants shunned them (causing their prices to fall), embraced bonds (depressing their yields) and remained fretful for the next two decades. The “Go-Go” years on Wall Street during the 1960s finally raised investors’ spirits – and recessions and bear markets from the mid-1970s to the early-1980s crushed them.
What’s Changed since the 1970s?
Figure 1’s and Figure 2’s trend lines slope slightly downward. That confirms the bulls’ expectation. Yet rates clearly don’t predict valuations: the yield’s variation explains only 2.9% of CAPE’s; myriad other factors or random noise comprise the other 97.1%. Moreover, valuations have been highest not when rates are lowest (i.e., 2% or below), but when they’re moderate (4-6%); and the lowest CAPEs have occurred over a very wide range of rates (7-15%).
Other key result undercuts the bulls: if the influence of rates upon valuations were fundamental and innate, then it would exist irrespective of time. Yet we observe very much otherwise: between 1881 and 1973, no relationship existed (Figure 3); and since 1974, a relatively strong one has prevailed (Figure 4). (Using the simple PE rather than CAPE, R2 = 0.01 for 1881-1973 and 0.19 for 1974-2020.) Until the early-1970s, long-term rates were mostly moderate, varied little and fluctuated without trend over long periods. In sharp contrast, by the late-1970s they exceeded 14%; since then, they’ve fallen almost continually – and are now well below 1%. It’s ironic: before the 1970s, when central banks intervened relatively little (at least in peacetime), long-term rates were relatively moderate and comparatively stable. Since then, however, they’ve intervened increasingly frantically, almost constantly and cumulatively drastically. As a result, rates have lurched from one extreme to the other.
Figure 3: Shiller’s CAPE and Long-Term Rates of Interest, U.S., 1881-1973
Figure 4: Shiller’s CAPE and Long-Term Rates of Interest, U.S., 1974-2020
In Australia, we possess valid and reliable earnings data (and hence the ability to compute the All Ordinaries Index’s PE ratio) since 1974. Broadly speaking, the relationship (Figure 5) corroborates the bulls’ contention: the higher is the rate, the lower tends the multiple. Yet as in the U.S., so too in Oz: the relationship isn’t particularly strong. Indeed, at virtually any long-term rate of interest above 4%, PEs have been both low (10 or below) and high (above 15). In this country, long-term rates explain less than 20% of the variation of the Index’s PE ratio since 1974. That’s half as much as in the U.S. (as measured by CAPE) and the same amount (as measured by the S&P’s PE) during this period.
Figure 5: PE Ratio, All Ordinaries Index and Long-Term Rates of Interest, Australia, 1974-2020
“The Faith of a Non-Churchgoing People in the Mystical Powers of Central Bankers”
Let’s recap. Do long-term rates determine stock markets’ valuations? Certainly not: myriad factors, some of which counteract others, are at play. Do rates influence valuations? In Australia and the U.S., the evidence is underwhelming: since the 1970s, they are one of the factors that have influenced valuations. But they’re hardly the only one, and arguably aren’t the most important. And looking further back into U.S. history, they’ve often been unimportant.
So why, by value investors’ standards, are major indexes in both countries presently so stretched? If fear and long memories prevailed until the mid-1960s, then complacency, historical myopia and above all blind faith in central banks’ “emergency” monetary experiments (which have seemingly become permanent) and governments’ ever more extreme fiscal “stimulus” have predominated since the mid-1990s. James Grant (“Monetary Activism Is a Virus That Infects Politics and Destroys Wealth,” The Financial Times, 6 January 2015) encapsulated this distemper of our times:
The virus of radical monetary intervention has entered the world’s political bloodstream zero per cent interest rates now pass for mainstream central banking doctrine … The heirs of today’s bondholders will read with amazement the history of post-2008 monetary policy. They will marvel at the faith of a non-churchgoing people in the mystical powers of central bankers. They will mourn the destruction of the wealth their forefathers entrusted to feckless governments …
Self-satisfaction, historical myopia and blind faith obviously provide no rational basis for asset allocation. Equally clearly, investors worthy of the name cannot expect artificially low rates of interest to sustain markets. That’s because they can’t rely upon central banks. The Bank of England, Federal Reserve, RBA, etc., inevitably fail because they’re central planners. Central planners inexorably fail because (it’s pointless to deny it) they’re socialists – and socialists inevitably fail because, as Margaret Thatcher once quipped, they eventually run out of other peoples’ money. Bluntly, central banks and governments don’t dispense “stimulus” – they peddle poison. That’s the conclusion of this series’ next (third) episode.