You have surely heard during your MBA days about how interest rates and stock markets are inversely related, right? Let us break that myth today.
For over a decade, experts (especially the bears) felt that low-interest rates were the principal reason why share markets were up. They said that the investors had no choice, but to seek higher risk to get higher returns! Even internationally, when interest rates went up, they were sure that the markets had to come down. This is wrong thinking. Interest rates don’t rule the share markets.
This stems from the belief that bonds and shares are fighting for a share of one pile of money – and the money will go to the more favourable asset class.
On one side: bond yields, like Gilt 10-year rates, which are currently yielding about 7.5%. On the other: stocks’ earnings yield – the inverse of the price/earnings ratio, (the earnings return shareholders would get forever if earnings and price remain constant.) is at 4%. Conventional wisdom holds stocks’ earnings yield must reasonably exceed Treasury yields to be worth their volatility.
Excellent theory and our economists made us believe that. However, in real life, the INFLATION adjusted earnings grow over time when the economy does well. The equity markets go up anticipating this rise. So even though the market may go down in the immediate short run, in the longer run the market goes up – adjusting for the inflation!
In the longer run, businesses expand, innovate, collapse – and money gets re-allocated to more profitable avenues. Even today some companies like Coal India, Indian Oil Corporation etc. are available at dividend yields of 10% pa. This is of course to be tempered with the thought that there could be a capital loss in say 5 years, but as a standalone valuation, it surely looks attractive considering that the main shareholder is the government of India. Business-cycle volatility makes earnings yields especially prone to skew around market lows. Are we in a market low now?
No. I have my reservations about valuations and there is a lot of uncertainty about the Indian elections of 2024. I have my doubts because the share market looks forward, while the earnings are for the immediate past. Hence the projected PE for the markets is more important than the immediate past, especially, since the market looks forward. Analysts’ earnings projections look a little lower if the immediate past has been a little low. That’s human nature.
Let us take an American example of the recent past.
Take the case of the year 2000, in the United States, the average gap between 10-year Treasuries and the S&P 500′s earnings yield using projected earnings was 2.23 percentage points through its entire – near today’s 1.89-percentage-point spread. US stocks didn’t mind. They rose 121% in US dollars.
High bond yields don’t hurt bull markets! Consider the US in the 1980s and 1990s. The US had a cracking bull market.
PV Subramanyam
writes at www.subramoney.com and has authored the best seller ‘Retire
Rich - Invest C40 a day’