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