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Who's nervous?

| July 06, 2021

Seems like every time you turn around, there is a story about how investors are worried and nervous. Worried that valuations are too high and the market is ready to fall, and therefore don’t know what to do with long-term savings. I’m not here to tell you that I have any different feelings, but that is the main reason we implemented our model – so that our “feelings” don’t dictate our investment decisions. Let’s look at the big picture for all this.

10-year Treasury rates are hanging out near recent lows and many “experts” are saying they could go down toward 1% again (they were talking of rates hitting 2% just a few short months ago…):

Meanwhile the “stock markets,” or as we like to use the Equal Weight S&P 500, is close to all-time highs.

Does this make any sense?  Sure, over the short-term equity markets have a high correlation to current interest rates. Why? Let’s look at a couple reasons.

  1. We’ve talked about this before, but it’s called TINA (“There Is No Alternative”…not the llama from Napoleon Dynamite). That means that with rates so low, investors look to other investments to provide some reasonable amount of return. Since inflation is running at roughly 2%, bonds will lose 1% per year in ‘real’ returns.
  2. As a function of evaluating markets and what price is the right price to pay, a smaller interest rate allows a higher price to be paid. Let me give you some detail on this (you can also reference our past blog piece, “Why interest rates matter”
    1. Various methodologies of valuing securities use a discounted cashflow model that incorporates a “risk-free” rate. The time period that money is invested for will dictate which “risk-free” rate you use. For us, we use the 10-year Treasury because most retirement money is invested for periods longer than 10 years.

The formula looks something like this:

Wait, nobody said there would be math involved! The hardest part about this equation is getting the data and how good that future cash flow expectation data turns out to be (good in = good out, garbage in = garbage out).

Another approach that many take is to instead take the price of the market and divide it by the earnings to figure out if the market is cheap or expensive. We know what the price is of the market.

What do earnings look like?  We will use operating earnings provided by our friends at Ed Yardeni Research.

As you can see, earnings for 2021 are expected to be $195 per share and $205 per share in 2022. These are considerably above 2020 levels (which were greatly affected by COVID), but even significantly higher than 2019 levels of $162 per share.

If we take our current level and divide it by our earnings for the year, we get a current valuation of around 22x earnings. Definitely not cheap, but with risk-free returns at 1%, not expensive in relation to that. If we back into the comparison number, we take 1/22, which equals roughly 4.5% compared to the 1% risk-free rate.

Of course, your question (for all the ‘A’ students in the front of the classroom), what if the 10-year Treasury goes back up to 2% or 3%? That’s a great question. If we plug in a higher risk-free rate, the amount you are willing to pay for stocks must go down. One could argue that the market is already discounting a higher treasury rate, otherwise it would trade at 30- or 40-times earnings (which it’s ‘only’ at 22 now).

Here’s a much simpler way to look at over-valued versus under-valued.  This comes from our friends at Riverfront. Looking at large cap US stocks, they use a historical growth rate of 6.4% on a logarithmic scale (see below).

You can see in the above chart, that we are above trend, but you can also see that markets tend to stay above or below for longer periods of time.

As you know, I believe the markets and economy will hold together as long as governments continue to prop up economies with more and more debt. Ok, admittedly I don’t like the way this is playing out, but I’m not making the rules, I just have to play within these rules – and hopefully recognize when those rules have changed. So far, so good for now. It also doesn’t mean I don’t worry about things, but hopefully I get to worry about things so you can enjoy other parts of your life.

I’ve thrown some heavy stuff at you for this week, I’ll let you digest that and next week we will have no math, I promise. We hope you had a great 4th of July weekend, and wish you a great week ahead!