If we look in the simplest possible way, there’s a relatively strong relationship between the interest yield on Treasuries and the earning yield (1/PE) on stocks. That’s because stocks and bonds are the two main kinds of liquid long-term investment, and both react in varying degrees to rate shifts.
Remaining simple, that relationship is probably best described as: interest yield = earnings yield. So, taking the 10-year T note as a proxy for bonds in general: if the interest yield is 4.27%, the PE that puts the S&P 500 in equilibrium with Treasuries should be 1/.0427x , or 23.4x current earnings. If we take the 30-year at 4.4%, then the equivalent PE is 22.7x.
Based on consensus estimates, the PE on coming 12 months’ earnings is about 22x. If that’s correct, and based on my simple model, stocks and bonds are roughly in equilibrium today.
If the 10-year yield were to drop to (I’m just making up a number) 3.5% over the next year, then the equivalent equilibrium PE for stocks would be 28.5X current earnings, or a level about 25% higher than where they are now.
How likely is that?
The Fed’s announced target for inflation is 2% (I believe a more realistic one is 2.5%, or maybe a tad higher). Add to that a real yield of 1.5% (meaning a return in excess of compensation for inflation), or about what the real yield was during the ten years before the pandemic, and the Fed’s nominal target is 3.5%. Getting to 3.5% is certainly a possibility. But the Fed has been trying its best to land there for about two years, without total success. The domestic economy has been too strong.
This continues to be the situation, despite Wall Street’s most heralded strategists continuously predicting that a sagging GDP, triggering a sharp drop in rates, was just around the corner.
In my view, there’s no reason to believe that Wall Street’s forecasting ability is going to miraculously improve. I think it’s highly unlikely that rates are headed up. More than that, I have no clue. My main takeaway is–great if rates start to decline, but this can’t be the heart of my equity investment strategy. Instead, it’s got to be finding hotspots of growth …that are mostly bets on individual company earnings coming through in a way that the consensus has underestimated.
more tomorrow