Interest Rates and Market Behavior: 5, 10, and 20 Years Ago

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Apr 16, 2015 1:43:00 PM

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interest ratesYesterday’s post on jobs made some interesting points about the relative performance of the economy today and in previous decades, highlighting both strengths and weaknesses of the current recovery.

A look at financial figures over the same time periods offers a different but equally interesting set of observations.

March/Q1

2015

2010

2005

2000

1995

1990

10-year Treasury rate

2.04

3.73

4.50

6.26

7.20

8.59

S&P 500

2,079.99

1,152.05

1,194.90

1,442.21

493.15

338.47

S&P 500 TTM PE ratio

20.21

19.19

19.57

29.41

15.38

15.69

Mortgage interest rates

3.77

4.99

5.76

7.92

8.08

9.73

FHFA House Price Index

213.95 (2014)

183.93

216.93

144.08

112.88

100 (1991 Q1)

Source: Haver Analytics

I lined up interest rates and stock values and valuations because financial assets are inextricably linked. The changes can provide some useful information about how normal (or not) current figures are, and what that might mean over the next couple of decades. Mortgage rates and housing offer a similar and supporting look at interest rates and asset prices.

The relationship between interest rates and stocks

U.S. Treasury rates have dropped consistently, despite some volatility, for 25 years. Think about that: very few trends last so long. Rates today are less than a quarter of rates in 1990. Mortgage rates have dropped almost as much, in terms of percentage points, but only to just over a third, rather than less than a quarter, of 1990 levels.

Stocks are typically valued with respect to interest rates; at lower interest rates, stocks are worth more. We can conclude that the decline in interest rates should have helped push stock prices higher, and we see exactly that.

The difference is explained by the rise in stock valuations, from about 16 to around 20 times earnings. Much of that rise in valuations can be attributed to the decline in interest rates. You can see the consistency of this change in the 2005–2015 numbers as compared with the 1990 and 1995 numbers.

The reason is simple: the implied return, from earnings, on a stock purchase is the reciprocal of the P/E ratio, or E/P. The P/E ratio of 15.69 in 1990 represents an earnings return of 6.3 percent, which is actually below the Treasury rate at that time. The current P/E ratio of 20.21 equates to a return of 4.95 percent on earnings, which is well above the current Treasury rate. The significantly lower interest rates of the past 10 years should result in higher valuation levels than in the 1990s, and that is what we see.

Arguably, with interest rates dropping by about 6.5 percent, you might even have expected valuations to increase by much more, and we saw just that in 2000. Even there, though, the implied return of 3.4 percent is about 3 percent less than the 6.3 percent of 1990. We saw the same behavior in mortgage rates and housing prices, with declining rates pushing up prices to very high levels, and then to a collapse, and then back up.

The fact that two very different asset classes showed the same behavior, for essentially the same reasons, indicates that interest rates are indeed a fundamental determinant of market behavior, in accord with what theory would suggest.

What does this mean for the future?

If rates were to increase—which at some point is very probable, verging on certain depending on the time frame—valuations could reasonably be expected to adjust back down to make earnings-based returns more consistent with the higher rates.

There is no reason to expect this will happen immediately, as rates may remain low for some time. Equally, if rates adjust while earnings continue to rise, we may see the valuation adjustment occur without a stock market correction. Either way, this is another pending headwind for the market, highlighted by the still very favorable interest rate conditions we now have.

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