Tuesday, July 13, 2010

On the Relationship Between Earnings and Yield

Trader's Narrative (hat tip Abnormal Returns) has an interesting piece from Wayne Waley (CTA) about the relationship between S&P earnings and interest rates. His conclusion following an analysis of data since 1970:

During periods of extremely low interest rates, stocks can reasonably be expected to sell in a P/E range somewhat higher than the historic 10-20 range. It is difficult for me to envision the P/E’s going to single digits during this bear market cycle (as has been the case in many previous inflationary bear markets) - unless the single digit P/E’s come far down the road when interest rates are much higher (above 5%).
Based on this conclusion, he believes stocks are trading at a low end of the range. There is an obvious flaw in his analysis, one that even Wayne points out in his devil's advocate 'argument that a bear would make':

If you go back to the 1950s or 1930’s you can find cases where the above interest rate/earnings relationship fails.

Actually, if you go to any point before 1970 (going back to 1910)... there were no other extended periods with a strong relationship between the two.

Earnings vs. Rates (in this case the 10 year interest rate rather than the blend)

Ten Year Rolling Correlation Between Earnings Yield and Ten Year Treasury Rates

Two questions I personally want answered:

  1. What happened in 1970 that would have caused the relationship between the two (initial thoughts include demographics [i.e. baby boomers], the growth of retail investing, and the increased debt added throughout the financial system)?
  2. Whatever the answer to #1, will that/those relationship(s) remain in an economy that faces deleveraging and a rebalancing within the global economy?

Source: Irrational Exuberance


  1. This is a fascinating graph. I'm wondering if it doesn't just reflect the possibility that investors started to see bonds as a competing asset class in the 1970s. That was a time when inflation started to pick up, bond prices became more volatile, ERISA was enacted and pension funds started to get more focused on their investing.

  2. DIY- i get the inflation thing (inflation make bonds less attractive), but are you saying ERISA caused pensions to allocate more to equities due to "expected returns" that now flowed through their balance sheets / income statements?

    recent ERISA changes make long duration fixed income much more attractive than previous and could be a cause for a breakdown in the relationship going forward (i.e. bonds might get relatively more expensive than equities, which appears to have been very rich for quite some time).

  3. Jake- When I started in the business investing was a lot less supercharged. Bank trust departments controlled money and they weren't very active. If pension accounts had 30% allocated to stocks they were seen as aggressive. Interest rates were somewhat controlled via "Reg Q" and commissions were high to do trades. Bonds were seen as steady but boring. Investment banks aggressively trading bonds wasn't a significant activity. Then it all changed with inflation picking up and technology leading the charge. Pension funds became accountable to their pensioners, bond prices dropped sharply and the DJIA finally broke through 1,000. All of these contributed to looking at stocks and bonds as competing asset classes and got people to look closely at their relative valuations. I believe these developements played an important role in the subsequent move in their relative yields.

  4. great insight and makes a ton of sense. if that is the case, wouldn't that make it likely that the relationship should hold?

    if so... perhaps equities have some room to move.