Big debate on the impact of rising bond yields on equity markets. Pretty simple actually, at least in theory.
Bond yields impact equity markets in 2 ways:
- To the extent that bonds yield fluctuations reflect changing investor expectations on economic growth, earnings expectations will likely change.
- To the extent that bond yield fluctuations reflect changing inflation rates, earnings multiple will be impacted.
The relationship between inflation and PE multiples is pretty straightforward. The Rule of 20 states that fair PE multiple for the broad market is 20 minus inflation. US inflation is currently 1.0%, indicating a fair PE of 19x trailing earnings. If inflation rises to 2.0%, fair PE declines to 18x, a 5% negative impact on valuation.
At this point in the cycle, inflation threats are very low with continuing deflation risks. Domestic US resource (capacity and labor) utilization rates are nowhere near levels that would induce price pressures.
However, if rising bond yields reflect a better economic outlook and higher credit demand, corporate profits should be positively impacted. When this happens in the early stage of an economic recovery, the economy can accelerate without creating inflationary pressures. In such a case, equity markets would gain with rising bond yields, until such time when inflationary pressures would surface.
Currently, US bond yields are normalizing post the double-dip scare and QE2 euphoria. Recent economic trends no longer support a double-dip scenario and the likely tax extension deal should bring higher GDP growth in 2011 than recently forecasted. Real 10-year interest rates were 1.5-2.0% last spring, within the long-term range. Inflation rates having since declined from 2.0% to the 1.0% area, 10-year treasuries should eventually stabilize between 2.5-3.0%.
Rising long-term rates are negative for stocks toward the end of the cycle when monetary policy is tightening to combat rising inflation or inflation expectations.
The theory is supported by the facts. In 1966-67, 1971-72, 1974-75, 1982-83 and 2009, equity markets kept rising while bond yields increased. In all cases, inflation rates were stable to down and monetary policy was stimulative. Other periods when long-term rates rose and equities declined were characterized by rising inflation and/or short-term rates which hurt investor confidence in the duration of the economic and profit cycles.
The S&P 500 index (1235) is trading at 15.6x trailing 12 months EPS. With 1.0% inflation, the Rule of 20 fair PE is 19x, implying a 1500 fair index level for a nice 21% upside potential. The consensus estimate for Q4/10 is $21.75, flat with Q3 but up $4.59 (27%) from Q4/09. This would bring TTM EPS to $83.61. On that basis, the S&P 500 index is selling at 14.8x TTM EPS in 3 months time. If inflation stays in the 1.0% range, fair market value would be 1589 for another 6% upside.
Previous threats to this positive scenario have almost all faded away. The double dip scenario is now highly improbable. In fact, the US tax extension package will likely boost 2011 growth by 0.5-1.0%. This also takes care, for now, of the deflation risk. And the Fed is clearly on equity investors side with as many QEs as will be necessary.
Of course, concerns remain, which is why the market is so cheap. Listen to David Rosenberg:
There is still plenty of unfinished business from the need for dramatic anti-inflationary policy tightening in the emerging market world, to radical surgery at the state and local level in the United States, to the relentless fiscal challenges that lie ahead in much of Europe. A Bloomberg national poll shows that over 50% of Americans feel they are worse off now than they were two-years ago when President Obama took office and two-thirds believe that the country is headed in the wrong direction.
We need to remember that there is no need for a booming economy for equities to rise. Reasonable top line growth coupled with rising productivity will produce good profit gains. In any event, the current appealing valuation uses trailing earnings. As long as nothing serious comes up to quench liquidity and totally reverse economic and inflation expectations, markets should move toward fair value. Remember uncle Ben’s put!
That said, we must agree that world macro risks are above normal which justifies discounting valuations by some prudence factor. Using a 10% discount, the target is 1350-1430 for a 10-15% capital appreciation potential plus a nice and rising 2% dividend yield.
The above analysis takes no account to the extraordinary amount of cash in corporate America’s balance sheet. At current low interest rates, this cash contributes essentially nothing to profits and thus artificially boosts PE multiples. See my December 6 post CASHING IN WITH CASH.
The S&P 500 has been trading within a 1050-1220 channel over the last 15 months. The fibonacci 61% retracement has quietly been breached in recent days. The December 6 chart below from Chris Kimble reflects the technical hurdle that made many nervous. We have since moved to 1235. Perhaps we should all stop biting our nails and buy stocks.