A common phrase often overheard on your favorite financial news channels goes something like this: “Stocks are cheap relative to bonds.” After all, the dividend yield on the Dow Jones Industrial Average is now on par with the 10 year Treasury. Relative valuations can be dangerous and are more often than not an attempt to justify too-high prices, but there is a theoretical and historical relationship between equities and interest rates. All other things equal, a lower risk-free rate (i.e. Treasury yield) lowers the discount rate used to value the cash flows of risky assets (i.e. equities), giving us a higher valuation. The reverse has also held true; the equity market bottomed out in the early 1980s with a single digit P/E and Treasury yields in the mid-teens.
Below is a chart that we’ve been watching with interest. It’s a variation of other charts you’ve possibly seen (for instance, David Rosenberg runs one using the 2 year Treasury yield) depicting a correlation that doesn’t necessarily jibe with “normal” ideas about valuation.
Back in the summer of 2007, the yield on the 10 year broke to the downside a few months before equities followed. The 10 year also led the S&P in the massive bounce off the March 2009 lows. The recent divergence began in the early summer of 2010, with the 10 year seemingly signaling more weakness ahead while the equity market is holding strong in positive territory for the year.
How long is it likely to last? Which market is “right?”
We don’t know. But we do know that the positive correlation between yields and equity valuations isn’t a recent phenomenon. In the chart below, we look at equity valuations instead of price, using the price/book ratio versus the 10 year yield.
The positive correlation between risk-free rates and equity valuations has been with us since the bursting of the equity bubble roughly 10 years ago. Through the 5 year period ending 12/31/98, the correlation between the S&P price/book ratio and the 10 year Treasury was a significantly negative -0.73. Since the end of 1999, the correlation is 0.88, a strong positive reading.
As abnormal as this seems, there is some historical precedent: Japan.
In Japan, the positive correlation began with the bursting of their own equity bubble and has lasted for nearly 20 years. The more “expensive” bonds became, the “cheaper” equities got.
Why does the relationship between risk-free rates and equity valuations seemingly change? We believe it’s likely that the world hasn’t been turned on its head, and lower discount rates don’t equal higher stock prices. The discount rate is only one part of the valuation picture, the other part being the estimate of future cash flows. These estimates depend on growth rates, which are based on expectations for real economic growth and inflation. Low risk-free rates signal low real economic growth and low inflation, which means that expectations of future cash flows are likely being downgraded. It’s likely that lower cash flow assumptions are overshadowing the discount rate effect. It’s also possible that the historical relationship between Treasury yields and equity valuations doesn’t work the same at abnormally low rates. Perhaps the relationship is nonlinear, or the discount rate has a lower bound (or both, like the Taylor rule for monetary policy).