Monday, June 1st, 2020

Stock Prices versus Interest Rates


Should you be buying calls or puts on the S&P 500? The common wisdom these days is that stocks are overpriced so you should expect a correction and buy puts. However, a recent opinion offered in CNBC says that stocks are not overvalued.

The S&P 500 is now trading at the highest price-to-earnings (P/E) multiple that stocks have seen in a decade, roughly 22 times its last 12 month’s earnings, according to data compiled by S&P Capital IQ.

However, according to economist Alan Reynolds, senior fellow at the Cato Institute, the market shouldn’t be looking at P/E in a vacuum. Instead, he maintains the key indicator is earnings yield-the inverse of the P/E ratio-and how it moves with interest rates.

“It makes no sense to say that stock prices are too high unless you also say that bond prices are too high,” said Reynolds, who was part of President Reagan’s OMB transition team in 1981. “I think bond prices are too high but so does the stock market.”

Reynolds has graphed the S&P 500’s earnings yield against the benchmark U.S. 10-year Treasury note going all the way back to 1970. He found that earnings yields track quite closely with bond yields. And since yields move in the opposite direction of price, the prices of both stocks and bonds have risen steadily over the past few years.

Reynolds says with bonds offering 2.1% interest a rate increase by the Federal Reserve is long overdue.

When Rates Go Up

It is probably time for the Fed to raise rates, but then there will be fallout. The Wall Street Journal reflects on the dollar’s strength and how it complicates raising rates by raising the value of the dollar.

The dollar climbed by about 13% against a basket of other currencies over the six months ended March 31. Some of the effects appeared quickly. In March, the U.S. trade deficit rose to $51 billion, its widest gap since 2008, as U.S. exports became more expensive and imports became cheaper. The economy contracted by a 0.7% annual rate in the first quarter, nicked in large part by a 14% decline in exports, the biggest drop in six years.

According to Ferbus, a 10% increase in the exchange rate ripples through the economy gradually. In the first quarter after the shock, growth is shaved by a negligible 0.08% and the inflation rate by 0.1 percentage point. But the impact grows steadily for three years, as producers, exporters, importers and consumers adjust their habits. After two years, about 0.75% will have been lopped off GDP.

This is part of the stock prices versus interest rates equation. If rates go up exports go down. Imports go up and the US economy suffers. Stocks go down as well. If we are already expecting a market correction we may expect it sooner if rates go up.

Not Yet?

The Financial Times says that the US economy is still too weak to justify a rate increase.

“If consumer behavior is still being impacted by the experience of the financial crisis, the Great Recession, and the painfully slow recovery, then it is possible that the economy will not be as robust as many economic models would suggest, because the models do not take into account this behavioral change.”

The underlying factor of stock prices versus interest rates may in fact be the new attitude of investors post Great Recession. People are saving more. Because they all want to buy bonds they are driving rates down and because they all want to get into the stock market they are driving prices up. So long as this lasts it may be smart to hedge your bets and buy a few calls.

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