Do low yields justify high stock prices? No. Yes. It depends.

Do low bond yields really translate to higher stock prices? Multi-Asset Strategist Ben Cooper explores the underlying index data to weigh three possible answers to this question.

Views expressed are those of the author and are subject to change. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional or institutional investors only.

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:

  1. 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.
  2. 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.

FIGURE 1

Relationship between P/E ratio and US Treasury yields

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.

FIGURE 2

Relationship between P/E ratio and US Treasury yields (excluding TMT bubble)

It depends

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.

FIGURE 3

Relationship between P/E ratio and BBB US corporate bond yields and spreads

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.

Please see the important disclosure page for more information.

RECOMMENDED FOR YOU

Endowments, foundations, and nonprofits: Research and investment ideas
Explore this curated collection of insights designed to help nonprofits navigate market dislocations and opportunities.
October 2020
Endowments, foundations, and nonprofits: Research and investment ideas
,
Financial Market Review: Third quarter 2020
A quarterly review of results in the global equity, fixed income, currency, and commodity markets.
October 2020
Financial Market Review: Third quarter 2020
,
Monthly Market Snapshot: September 2020
A monthly update on equity, fixed income, currency, and commodity markets.
October 2020
Monthly Market Snapshot: September 2020
,
Sustainable investing in 2020 and beyond
This event replay features a panel of leading experts from Wellington Management, the PRI, and Harvard Business School and offers topical insights into sustainable investing.
October 2020
Sustainable investing in 2020 and beyond
,
<span>Insurance Multi-Asset Outlook — </span>Politics, policy, and the pandemic
Tim Antonelli and Daniel Cook share their latest multi-asset outlook for insurers, including upside and downside risks in today's extraordinary environment.
October 2020
Insurance Multi-Asset Outlook — Politics, policy, and the pandemic
,
2020 US election
The 2020 US election is perhaps the most politically contentious spectacle of the modern era. Investors around the world are increasingly asking how this momentous event may affect geopolitical dynamics, economic policies, and capital markets. This collection offers our latest thoughts, including how investors might position for November and beyond.
October 2020
2020 US election
,
<span>Multi-Asset Outlook — </span>Politics, policy, and the pandemic
How will US election risk, policy support, and progress toward a COVID-19 vaccine balance out? Nanette Abuhoff Jacobson and Danny Cook offer their view on the next 6 – 12 months and consider the asset-class implications.
October 2020
Multi-Asset Outlook — Politics, policy, and the pandemic
,
Monthly Market Snapshot: August 2020
A monthly update on equity, fixed income, currency, and commodity markets.
September 2020
Monthly Market Snapshot: August 2020
,

We use cookies to improve your experience on our website. To accept cookies click Accept & Close, or continue browsing as normal. For more information, visit Cookies & Tracking NoticE.