Do higher interest rates spell doom for stocks? There is growing talk that they may. As interest rates move higher, bonds can become a more attractive investment option for investors than stocks. Yesterday the yield on the 10 year Treasury bond closed above 3%, its highest level in over 4 years. If it goes a whisper higher, it will be at its highest level in almost 7 years. While interest rates have stalled around this level before, a yield of 3 1/2% looks probable in the not too distant future.
Let’s say the yield does shoot higher. Does this spell doom for stocks? I don’t think so. Even if the 10 year Treasury yield went to 3 1/2%, this return would just enable an investor to break even after inflation, assuming a long-term average rate of inflation of about 3 1/2%.
Digging deeper, I have examined the historical spread (meaning difference) between the yield of the 10 year Treasury versus the earnings yield of the S&P 500. The earnings yield of the S&P 500 is simply the inverse of the P/E ratio (price divided by earnings). Over the past 30 years the earnings yield has averaged about .7% more than the yield of the Treasury bond. At a 3% Treasury yield, this equates to 26.9 being a reasonable P/E ratio for the S&P 500; at 3 1/2%, this equates to 23.7 being a reasonable P/E ratio. Using the operating earnings estimates for the just completed 1st quarter, the P/E ratio of the S&P 500 is currently around 20. If earnings expectations for 2018 prove accurate, the P/E at the end of the year would be around 17 using the current price of the S&P 500. What all this means is that even if interest rates do go up to 3 1/2%, stocks still remain more attractively valued than bonds based on this historic relationship. I believe it would take a Treasury yield of 4.25% to tip the scales in bonds’ favor.
The fear of rising rates could of course stall the stock market, but at this moment I believe the current pause in stocks to be temporary for the reasons I have noted in my previous communications.
Glenn S. Rank, CIMA®
Certified Investment Management Analyst®