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MANY INVESTORS ASSERT THAT LOW BOND YIELDS RESULT IN HIGHER STOCK PRICES. In isolation, this clearly makes sense: as the discount rate falls in the denominator, the net present value of the stock increases. However, we also need to consider other dimensions, such as credit risk, and how these also play a role in setting price-to-earnings (P/E) ratios.
Here, I explore the underlying data at the index level (the MSCI USA Index, 1975 to present) to weigh the three possible answers to this question: no, yes and it depends.
The ‘no’ case
The argument against low yields justifying a high P/E ratio is twofold:
- Treasury yields and earnings growth are correlated due to their common linkage to nominal economic growth. For example, low yields may be signalling lower nominal growth or higher macro uncertainty, which in turn is not good for earnings growth.
- The empirical evidence suggests that the relationship is an inverted V-shape (Figure 1) where the P/E ratio reaches an apex at a 10-year Treasury yield of 5%. This 5% yield is heralded as a sweet spot for the P/E multiple (the black vertical line). In contrast, the high yields of the 1980s (the dark blue dots) were “too hot”, and very low yields can be considered “too cold”. Bearish commentators point out that the current set-up (see dashed crosshairs) suggests stocks look overvalued.
The ‘yes’ case
The counterargument is that the 5% sweet spot is just a coincidence, and the inverted V-shape in Figure 1 is almost exclusively driven by the high P/E multiples in a single period: the technology, media and telecoms (TMT) bubble. If we strip out the 1998 – 2002 bubble period, the chart loses its inverted V-shape (Figure 2). This gets us back to square one: lower yields might justify higher valuations after all. But I believe the answer is more complicated than that.
The analysis above only looked at US data and Treasury yields. We know from international comparisons (e.g., with Japan) that extrapolating this trend can be dangerous. For this discussion, we will focus on credit. If we substitute US corporate bond yields for the 10-year Treasury yield, do we get a different perspective on the P/E-to-yield relationship?
Simply substituting corporate yields in aggregate would produce a very similar chart to Figure 2, just shifted to the right on the horizontal axis. But, if we instead group the data by spread level, the results are revealing. Figure 3 shows each group in its own panel and represents the data in each spread quintile. The far-left panel (with the bluish grey dots) represents the P/E ratio and yield data for the tightest spreads only, while the far-right panel (with the yellow dots) shows the P/E ratio and yield data for the widest spreads only. The conclusions:
- History shows that tight (wide) credit spreads are generally associated with high (low) P/E ratios. This is most clear in the average P/E ratios for each panel (see coloured horizontal lines), especially for tight spreads (Q1 and Q2) versus very wide spreads (Q5).
- The set-up in December 2019 (see black, dashed crosshairs in second panel from left) seems consistent with historical experience. Indeed, you can see a cluster of dots around the crosshair exhibiting elevated P/E ratios, low bond yields and tight spreads.
- Today’s set-up (see dashed crosshairs in far-right panel) shows far less historical consistency, with elevated P/E ratios and low bond yields but very wide spreads. This suggests that certain credit sectors continue to look cheap compared with equities.
In summary, I find empirical justification for the “low yields equals high P/E ratios” reasoning in the US data. But it depends on excluding data from the TMT bubble. Moreover, the supporting role played by credit spreads in setting P/E ratios seems generally underappreciated.