Any analysis regarding the appropriate valuation of a long-lived asset must account for the influence of interest rates. All else the same, a rise by the interest rates of lower-risk debt obligations, namely US Treasury debt, will reduce the prices of other financial and real assets. Whenever asset prices defy higher interest rates and rise, a worrisome overvaluation of asset prices may be unfolding. Today’s high price-to-earnings multiples of equities and narrow yield spreads of corporate bonds have increased the vulnerability of financial asset prices to a widely anticipated climb by short- and long-term Treasury yields.
As of 2017’s third quarter, the market value of US common stock was 15.4 times as great as the prospective moving yearlong average of US after tax profits. Third-quarter 2017’s ratio of common equity’s market value to yearlong after-tax profits was the highest since the 16.2:1 of second-quarter 2002. More importantly, the ratio last rose up to 15.4:1 in first-quarter 1998 and would ultimately peak at the 26.0:1 of third-quarter 2000. Stocks may be richly priced relative to after-tax profits, but that does not preclude a further overvaluation of equities vis-a-vis corporate earnings. (Note that the measure of after-tax profits employed in this discussion is from the National Income Product Accounts, excludes changes in the value of inventories and some extraordinary gains and losses, and uses economic depreciation instead of accounting depreciation.)
Today’s equity market differs from that of 1998-2000 for reasons extending beyond 1998-2000’s average aggregate price-to-earnings ratio (P:E) of 21.2:1, which was so much greater than the recent 15.4:1.
In addition, 1998-2000’s equity market seems even more overpriced compared to the current market because the recent 2.43% 10-year Treasury yield was so much lower than its 5.64% average of 1998-2000.
The valuation of equities very much depends on interest rates. Holding everything else constant, priceto-earnings multiples will climb higher as benchmark interest rates decline. If benchmark interest rates fall, the market will be willing to accept a lower earnings yield, or a lower ratio of earnings to the market value of common stock. At some level of corporate earnings, the attainment of a lower earnings yield will be achieved through an increase in share prices. To the contrary, a rise by interest rates will push the earnings yield higher. Barring a sufficient climb by after-tax profits, a higher earnings yield will require lower share prices.
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