A Policy Error Could Trip Up Stocks

Broadly investors have enjoyed strong returns in stocks over the past two years, the S&P 500 Index returned 31.5% in 2019 and 18.4% in 2020. Last year's return occurred in an environment where earnings for S&P 500 companies is expected to equal $133, down from $157 in 2019. This move higher in stocks at the same time earnings declined has pushed large company stock valuations to levels where one might say they are priced for perfection. One way to look at stock valuations is reviewing a measure called the Rule of 20 which states that stocks are fairly valued when the inflation rate plus the price earnings ratio of the S&P 500 Index equals 20. As the below chart shows this measure currently equals 23.4. If one uses the P/E based on the index's 2022 earnings, the measure equals approximately 20.4.

A number of various stock market valuation measures do look extended. The ones that do not looked extended are ones based on interest rates and it is true stocks can trade at higher valuations at lower interest rates, all else being equal. Because a company's future earnings are worth more when discounted back to the present at lower interest rates, this justifies stocks trading at higher P/E's. As seen in the below chart though, interest rates are trending higher. The yield on the 10-Year U.S. Treasury has moved up from the .50% level last March to a yield of 1.10% now.

This move higher in the 10-year Treasury is taking place at a faster pace than the increase in short term interest rates. This has resulted in a steepening of the 2y/10y yield curve.

One tailwind for stocks has been the low interest rate environment. As an investor, psychologically, it can be difficult to lock up one's money for ten years in a 10-year U.S. Treasury that only yields 1.10%. This environment has created a market that some strategist refer to as a TINA market, There INAlternative to stocks. One important observation in the above yield curve chart is the market has a history of pulling back when the curve steepens. One difference at this point in time is the fact the absolute level of interest rates is low, i.e., near zero; thus bonds providing limited competition for stocks.

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Disclaimer: The information and content should not be construed as a recommendation to invest or trade in any type of security. Neither the information nor any opinion expressed constitutes a ...

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