The “rationalization” that low rates justify high valuations is but one of several arguments used to justify overpaying for value in a late-stage bull market.
As discussed previously, one of the “bullish spins” for the market has been that “earnings are cheap” based on two- and even three-year forward estimates. As noted in “Is It Justifiable Bullishness:”
“In 2020, investors are again chasing “growth at any price” and rationalizing overpaying for growth. Such makes the mantra of using 24-month estimates to justify paying exceedingly high valuations today, even riskier.”
Such is also why there is the most significant disparity between growth and value on record.
This Time is Different
The belief this time is different from the past has always been the most dangerous of phrases for investors. However, this is where participants exist today. While it is true the excessive monetary liquidity has certainly changed short-term market dynamics; there is no evidence it has mitigated long-term consequences.
Moreover, investors are also relying on the belief that low interest rates justify overpaying for earnings and sales.
“Valuations don’t matter as much as they did in the past because ‘this time is different’ in that interest rates are so low.”
The basic premise of the interest rate/valuation argument has its roots in the “Fed Model” as promoted by Alan Greenspan during his tenure as Federal Reserve Chairman.
The Fed Model states that when the earnings yield on stocks (earnings divided by price) is higher than the Treasury yield, you invest in stocks and vice-versa. In other words, disregard valuations and buy yield.
There is a critical disconnect that needs to be understood.
You receive the income from owning a Treasury bond. However, there is NO tangible return from the earnings yield.
For example, if I own a Treasury bond with a 1% coupon and a stock with a 2% earnings yield, if the price of both assets doesn’t move for one year – my net return on the bond is 1%, while the net return on the stock is 0%.
Which one had the better return from 2000-present?
Yet, analysts keep trotting out this broken model to entice investors to chase an asset class with substantially higher volatility risk and lower returns.
Low Rates Don’t Justify High Valuations
An offshoot of the Fed Model to rationalize overpaying for assets is that low interest rates justify high valuations.
However, is the recent decline in interest rates, driven by massive global Central Bank interventions, really providing valuation support? The premise is that cheaper borrowing costs boost bottom-line earnings. The problem is that over the last decade, low rates have led to a deterioration in economic growth and prosperity.
The chart below takes the interest rate argument from a little different angle. I have capped interest rates from their “low point” of each interest rate cycle to the next “high point” and then compared it to the S&P 500 index. (The vertical dashed lines mark the peaks in the S&P 500 Index).