With US equity markets hitting new all-time highs, the narrative about valuations looking expensive continues to maintain traction. But while P/E ratios are indeed at the higher end of their historic range, we believe equities remain attractive when adjusted for interest rates and the fundamental backdrop.

For context, the next 12 months (NTM) P/E ratio for the S&P 500® Index is roughly 20x, which is higher than the 5-year average of 18x and the 10-year average of 16x. But a significant amount of money moved to the sidelines at the beginning of the pandemic in 2020, with assets in money markets rising by over $1 trillion. While some of that money has found its way back into stocks, the cumulative flow of assets to both money markets and bonds still significantly outpaces the flow to equities. So the question is, with all of this money not invested in stocks, should it be?

To the extent that investors have return objectives that are higher than current bond yields, we would suggest the answer is yes. Of course the price an investor pays – for a stock or a market index – is going to determine the value or return that can be achieved. But our base case is that the economy is going to continue to recover from the pandemic, and that growth will continue as the global economy opens up, businesses increase their investments and consumers return to prior spending habits.

Compared to What?
So, what about those valuations? This is where historical perspective can provide some insight. It’s helpful to view valuation in the context of company fundamentals and the interest rate environment, as bonds are always an alternative to stocks. For example, if you have a return objective of 6% annualized over the next 10, 15 or 20 years and US government bonds are yielding 6%, then you don’t need equities, unless of course there is inflation, which could easily be 2% – 3% annualized. But today, government bonds are not offering that kind of yield, and inflation could easily eat away half of those nominal returns. Let’s take a closer look at interest rates.

Interest Rate-Adjusted Earnings Yield Remains Attractive
The first chart in Figure 1 shows the earnings yield of the Spider S&P 500 EFT Trust (SPY) and the Invesco QQQ Trust (QQQ) minus the yield on the 10-year Treasury.

  • The SPY was trading at an interest rate-adjusted earnings yield of 3.44% as of 9/30/21, which is relatively attractive compared to history. (The higher the earnings yield, the more attractive.)
    • The data is monthly, so the SPY had an earnings yield of 4.97%, which is simply the reciprocal of the forward NTM P/E ratio of 20.1x.
    • The 10-year Treasury yield on 9/30/21 was 1.53%, resulting in the interest rate-adjusted earnings yield of 3.44% (4.97 minus 1.53).
  • The chart also shows that the SPY (in blue) is still more attractive than at any time prior to 2007. After the Great Financial Crisis, the interest rate-adjusted earnings yield was close to 8%. At the time, the 10-year Treasury yield was 2% and the forward P/E ratio was around 10x – clearly very inexpensive, regardless of rates. At the other extreme, in the late 1990s and early 2000s the SPY was trading at an earnings yield of -2.2%, so very expensive compared to bonds, as the 10-year Treasury yield was 6% at the time and the forward P/E ratio was 26x.
  • This was also true for the Nasdaq 100 Index, which had a negative interest rate-adjusted earnings yield of -3.41% as of 9/30/21. The Nasdaq 100 Index (QQQ) had an earnings yield of 2%, lower than the S&P 500® (SPY) and at the lower end of its range in the prior ten years.
ROE and Profit Margins Hitting All-Time Highs, Especially for Tech-Heavy Nasdaq
Very interesting, however, is that profitability for the Nasdaq 100 is very different today than it was in the late 1990s and early 2000s.

  • As we all know intuitively, the Nasdaq 100 companies are real businesses with strong profitability and Return on Equity. The QQQs have an ROE of 26.5% with net margins of 16.3%.
  • So while the earnings yield on QQQ is lower than the SPY, its ROE is 9% higher than the SPY ROE of 17.4% and its net margin is 4.6% higher than the SPY net margin of 11.7%.
  • For 2022, profit margins for the SPY are expected to expand even further, to 12.8%1 – more than 100bps. For the Nasdaq the expectations are for net margins of 15.7%, basically in line with the current margins, but we would argue this makes them easy to beat.
Given the strong fundamentals of US stocks, rising profit margins and return on equity combined with the low interest rate environment, we believe stocks remain attractive and will continue to march higher, albeit with the occasional, yet unpredictable, market pullbacks.

Figure 1 – Interest Rate-Adjusted Earnings Yield, ROE & Net Margins
Chart showing the Interest Rate-Adjusted Earnings Yields of Invesco QQQ Trust and SPDR S&P 500® ETF Trust from 1999 to 2021
Chart showing the Return on Equity of Invesco QQQ Trust and SPDR S&P 500® ETF Trust from 1999 to 2021

Chart showing the Net Margins of Invesco QQQ Trust and SPDR S&P 500® ETF Trust from 1999 to 2021

Standardized Performance
Chart showing the standardized performance of Invesco QQQ Trust and SPDR S&P 500® ETF Trust in the period ending September 31, 2021
Source: FactSet

1 Source: FactSet

Performance data shown represents past performance and is no guarantee of, and not necessarily indicative of, future results.

The SPY ETF was chosen because it is the largest and most commonly used ETF that represents the S&P 500 Index. The QQQ ETF was chosen because it is the largest and most commonly used ETF that represents the NASDAQ 100 index.

Exchange-Traded Funds (ETFs) trade like stocks, are subject to investment risk, and will fluctuate in market value. Unlike mutual funds, ETF shares are not individually redeemable directly with the Fund, and are bought and sold on the secondary market at market price, which may be higher or lower than the ETF's net asset value (NAV). Transactions in shares of ETFs will result in brokerage commissions, which will reduce returns.

The views and opinions expressed may change based on market and other conditions. This material is provided for informational purposes only and should not be construed as investment advice. There can be no assurance that developments will transpire as forecasted. Actual results may vary.

All investing involves risk, including the risk of loss. Investment risk exists with equity, fixed-income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.

CFA® and Chartered Financial Analyst® are registered trademarks owned by the CFA Institute.

3899448.1.1