I got a lengthy email from a friend in the EU about a week ago with general questions about the stock market. I thought I’d answer some of them here.

The stock market (I mean any stock market, but I’m mostly thinking about the US) is the arena where the hopes and fears of investors interact with the objective characteristics of publicly listed companies to figure out what those companies are worth.

There’s really no “pure” demand for equities; there’s a demand on the part of investors for liquid securities–ones that can most times be bought and sold at a fair-ish price almost instantly.

There are three types of these liquid securities: cash, bonds and stocks. The price of each has an influence on the prices of the others, with the biggest determinant being the level of interest rates (currency relationships can count as well, with the value of the US dollar being the most important). The main standard for interest rates is the interest yield available on the 10-year Treasury note, which is 3.53% as of last Friday.

If we pretend that a stock is a funny kind of bond, with our portion of company earnings, or earnings yield (1/PE), as the equivalent of the interest yield on a government bond, then we have a rough and ready way of gauging what the general level of stock prices should be so that they’re reasonable substitutes for bonds. This rubric says that a 10-year note at 3.53% is the equivalent of a stock market PE of 28x earnings.

If we think the highest the yield we imagine the 10-year could reasonably get to is 5%, then the market PE should be something like 20x this year’s expected earnings.

There are obvious practical problems with this equivalence, over and above its having been invented by finance academics. There’s no government guarantee in the case of stocks, for example, that we’ll get our money back after 10 years. Nor is there a promise by company management to pay out any portion of earnings as quarterly/yearly dividend payments.

One key fact, though is that in late 1981, the yield on the 10-year approached 16%, with the Fed Funds rate breaking higher than 20% for a short period that year.

For the 40-some following years, fixed income has been in a relatively steady downtrend–putting wind into the sails of common stocks–until bottoming at effectively zero during the pandemic. In the EU, for what it’s worth, the bottom was below zero.

That gigantic tailwind is now in the rear view mirror. So, it seems to me, it’s very dangerous to extrapolate from that extremely long period of good news on the interest rate front to what now lies before us–in both stocks and bonds.