As the current market rally has evolved, one of the main arguments against this being the start of a new bull market has involved valuations. While value metrics like the 10-year P/E ratio and Tobin’s Q have been low compared to historical standards, they haven’t gotten as low as they have in other past downturns. That, some say, means the market will likely tumble back downward until we hit or come close to the all-time low valuations we saw in, say, 1982.
On Forbes.com, however, Cato Institute Senior Fellow Alan Reynolds offers some interesting insight into this issue. “All of these gloomy projections of falling stock prices have been based on falling valuations, not falling earnings,” he writes. “We’re told the ratio of stock prices to earnings could supposedly fall below 10 simply because that happened before, in years like 1982.”
“But stock valuations are not just a matter of opinion, gyrating unpredictably between waves of optimism and pessimism,” he continues, showing graphs that indicate P/E ratios depend mainly on interest rates. Historically, the graphs show, the earnings yield of stocks (the inverse of the P/E) shows a remarkable tendency to track the 10-year Treasury bond yield.
The significance of this, Reynolds says, is that times when P/E valuations were around all-time lows — that is, when earnings yields were around all-time highs — occurred when interest rates were very high. Essentially, stocks commanded lower multiples because investors could get big returns on “safer” bonds.
Today, however, interest rates are very low. “Bearish economists … typically assume depressed demand and deflation — forecasts impossible to reconcile with the double-digit interest rates required to push the E/P ratio to 10 or more” and thus the P/E to 10 or less, writes Reynolds. “The height of today’s P/E ratio relative to the past tells us nothing except that (1) interest rates are far below average and (2) future earnings are very likely to rise from today’s depressed base.”
“Unless those who have spent the past two months predicting P/E ratios of 8-10 are also predicting a tripling of long-term rates,” Reynolds concludes, “their forecasts of stock prices are inconsistent and unworthy of the slightest attention.”