Heads up. There is a relationship between the value of stocks and interest rates. And, this relationship is probably different than you think. When yields on treasury bonds are extremely low, rising interest rates have a strong positive influence on stocks. As these yields move up toward 5% this relationship weakens. The chart below (Figure 6: Equity Sensitivity to Treasury Yields) shows the inverse relationship between stock prices and yields on the 10-year Treasury.
Note that in our post-financial crisis period, economic growth and interest rates collapsed relative to longer-term averages. So, while the overall relationship between yields and stock prices remains intact, it appears that this 5% threshold has likely declined. More specifically, as the chart below (Figure 7: Equity Sensitivity to Treasury Yields) highlights, markets should reward rising interest rates until the 10-year Treasury reaches a rate of three and one-half percent.
In December, the Federal Reserve Board plans to raise interest rates. What does that mean to the stock market? Well, while, conventional wisdom holds that the Fed influences equities through its short-term funds rate, the chart below (Figure 8: Equity Sensitivity to Treasury Yields) and the previous illustrations suggest that the market is far more tethered to longer-term rates. In fact, despite investors attributing the market’s extended rally to accommodative monetary policies, the data clearly shows that short-term rates lost their sway over stock prices once the uber-dovish policy began in 2008. This doesn’t mean that the market will never care about what the Fed does again, but it does imply that until central bankers successfully normalize policy, they will have far less impact on stock valuations than investors think.
So, in conclusion, historic data shows the market seems to prefer periods when rates are near some long-term average. As the chart below (Figure 1: Valuations vs. 10-Year Treasury Yield) shows, forward stock multiples (a leveraged driver to earnings) have been highest when Treasury yields are around 5%. It also infers that the market should reward rising interest rates when yields are below this 5% threshold, but punish shocks when yields drift above this critical level.
In summary, the relationship between rising price-to-earnings multiples should tend to begin to breakdown once yields on the 10-year Treasury reaches 3.5% in our post-financial crisis world. As the Fed hikes the Federal Funds rate in December and the labor market shows additional signs of tightening further pressure on longer-term rates will occur. This, along with changes at the Fed, is raising investor concerns that higher yields will impede the markets advance. However, conventional wisdom, that rising rates will hinder the market’s advance, may be misplaced. In essence, Credit Suisse analysts suggest this period of rising multiples may continue, logically, for two more years or more. We shall see.
Thank you again for your continued trust and support.
Resources: Jonathan Golub, CFA, Patrick Palfrey, Manish Bangard, CFA, et al, U.S. Equity Strategy, Higher Rates, Credit Suisse Equity Research Strategy, 11/13/17
Investors should be aware that there are risks inherent in all investments, such as fluctuations in investment principal. Past performance is not a guarantee of future results. Asset allocation cannot assure a profit nor protect against loss. Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Views expressed in this newsletter may not reflect the views of Bolton Global Capital or Bolton Global Asset Management. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. VW1/VWA0225