10 August 2023
A narrative that persisted during the decade of Quantitative Easing following the GFC was that central bank action had suppressed bond yields and, as a result, driven up the valuation of equities.
This makes sense; the long bond yield is the key driver of the discount rate that the market uses to price future cash flows, so low bond yields should increase the present value of a company’s future cash flows, and all else being equal, this should lead to higher PE ratios.
Yet over the past 2 years, as we have seen the US 10-year bond yield move up to over 4%, US equity multiples have stayed high, with the current S&P 500 CAPE ratio above 30x.
In fact, plotting the relationship between the 10-year yield and the S&P 500 CAPE ratio since 1998 shows a positive and not a negative relationship between yields and equity market ratings. Over the past 25 years, it looks like higher bond yields have meant higher equity ratings.
Source: Robert Shiller
So how do we reconcile this?
Firstly, if we look at a longer history back to 1960, the relationship becomes clearer.
Secondly, if we highlight the data between 1997 and 2001, we see that the four-year period leading up to and including the dot-com bubble is a significant set of outliers. Excluding that period (if one argues that market prices were not rational during that boom) shows an even stronger negative relationship between yields and the CAPE ratio.
Finally, though we don’t show the chart here, this relationship still holds (with a slightly lower R²) if we replace bond yields with real yields, suggesting that it is real rates rather than inflation expectations that drive the long-term multiple.
Source: Robert Shiller
With the S&P 500 CAPE Ratio above 30 times and 10-year yields near 4%, US large-cap equities look expensive relative to where yields are. But as the analysis above shows, these relationships only hold over very long time periods and may break down over multi-year periods.
In the late 90s, it was the growth of the internet and associated business models that kept the market irrational for longer than many investors could stay solvent; could the rapid progress of generative AI do the same this time around?
Our Market Snippets aim to provide concise insight into our investment research process. Each week, we highlight one chart that showcases our research, motivates our current positioning, or simply presents something interesting we’ve discovered in global financial markets.
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