So, where do you start exploring for investment opportunities?

by Finploris
0 comment

After an exceptionally high inflationary period in the 1970s, the US and the other industrialized countries have been in a trend of falling Treasury yields for four decades.

This chart shows 10-year Treasury yields in red compared with the cyclically adjusted price/earnings ratio of the S&P 500 in blue.

Chart Source: Professor Robert Shiller, Yale

Know when it’s been a good run and it’s time to end the night.

There is a significant long-term inverse correlation between long-term interest rates and S&P 500 valuations, although not on an annual basis. The main exception to this general trend of inverse correlation was the 1940s during World War II, when interest rates were low at 2.5%, inflation was high and the future was more uncertain than usual, which also led to low equity valuations.

Short-term yields have mostly been below the prevailing inflation rate for more than 10 years, meaning that bank accounts and Treasury bills have lost purchasing power over time.

How are you positioning yourself?

Lower interest rates allow for equity valuations to be higher, and incentivizes owning excess stock exposure, because it reduces the hurdle rate for investment.

If 10-year Treasury notes yield 4%, for example, and you want at least a 2% equity risk premium, then you’ll only invest in a stock if you think you can get an 6% annualized return or higher. However, if 10-year Treasury yields are 1.5%, and you still want a 2% risk premium, then you’re willing to pay a higher valuation, and thus accept a lower dividend yield and lower expected returns from stocks; even 3.5% expected annualized returns would be better than a 1.5% Treasury yield.

But the danger exists if interest rates run sideways or even rise structurally.

How do interest rates influence the markets?

Low interest rates have had different effects in different countries. In many industrialized countries such as Germany, low interest rates have caused real estate valuations to rise more sharply than equity valuations. In the USA, on the other hand, above-average amounts of capital have flowed into growth stocks.

In the US, people tend to be much more exposed to equities, and the rest of the world is also buying American equities, which has driven up the valuations of US equities more than the valuations of real estate in America. Housing prices in the USA are not much more expensive compared to the rest of the world, but the stock market is.

If those sound boring, have you ever thought of value investing? 

Growth stocks are more sensitive to interest rate changes than value stocks, and the S&P 500 has become very growth-oriented in recent years compared to most other international equity markets. Therefore, the US equity market is more susceptible to rising interest rates than many other equity markets that are more value-oriented.

You may also like