As the S&P 500® and Nasdaq 100 Indexes have sold off about 15% and 20%+ so far this year, it’s important to ask two key questions:
- Are equities getting more or less expensive relative to bonds?
- Equity valuations have come down, as interest rates have risen. Is now a good time to increase equity exposure?
Figures 1 and 2 show the Price-Earnings (PE) multiple based on the Next 12 Months (NTM) earnings estimates. The S&P 500® has an NTM PE of just under 17x, down from over 20x at the start of the year. The Nasdaq 100 has an NTM PE ratio of about 23x, down from close to 30x five months ago. So it appears as if valuations are cheaper.
Figure 1 – PE based on NTM earnings – S&P 500®
Source: S&P 500®, FactSet, as of 5/10/2022.
Figure 2 – PE based on NTM earnings – Nasdaq 100
Source: FactSet, as of 5/10/2022.
But do higher rates make stocks less valuable?
However, if we factor in how much interest rates have increased since January, there may be a different story to consider. There is a traditional approach that seeks to compare the value of stocks and bonds by looking at the earnings yield of stocks vs. the yield of bonds. One way to determine the earnings yield is to invert the PE ratio. For example, the inverted S&P 500® PE ratio, or earnings yield, is 1/16.8x or 5.9%. If the 10-year Treasury bond yield is 3%, then the additional “yield” an investor gets from owning stocks vs. bonds, in this case the 10-year Treasury, is 5.9% minus 3% or 2.9%.
Of course, stocks have significantly more risk than government bonds, so it makes sense that there is a premium for equities over bonds. With rates rising, much of this market volatility is simply a function of investors trying to figure out how to value stocks in a rising rate environment that has the potential to push the economy into recession. While stocks offer a very compelling Return on Equity (ROE), something that bonds don’t have at all, the question is how much should investors pay for those future earnings and ROE?
Where are we relative to history?
Figure 3 provides some historical perspective on how these stock indexes have been valued in the past through different interest rate environments. The chart shows an interest-rate-adjusted earnings yield relative to the 10-year Treasury yield over the past 20 years. In the early 2000s the Nasdaq 100 Index had an NTM PE ratio of about 30x, which means its earnings yield would have been 3.3%. If you subtract the 10-year Treasury yield at the time of about 5%, the interest-rate-adjusted earnings yield for the Nasdaq 100 would have been just under negative 2%. So stocks were very expensive relative to bonds. You will also note that the ROE at that time for the index was negative, so companies were losing money and investors were paying 30x NTM PE ratio. After the Great Financial Crisis, stocks became very attractive on this metric with the S&P 500® sporting an interest-rate-adjusted earnings yield of over 6% and then over 7% in 2011. So you can see that the higher the interest-rate-adjusted earnings yield is, the more attractive stocks are relative to bonds. Interestingly enough, the profitability of the S&P 500® and the Nasdaq 100 was very strong at that time.
Equities are generating higher ROEs and Net Margins than in the past
Fast forward to today and you will see that the profitability and/or Return on Equity has continued to grind higher for these indexes (Figures 4 and 5). US companies are more profitable and offer higher ROEs than at almost any time in history. Said differently, these indexes are dominated by companies that have really good businesses and as such, probably warrant higher PE ratios than in the past. And certainly, with the benefit of hindsight, higher multiples than in the early 2000s when some of these index companies were not profitable at all.
Despite the selloff and higher rates, equity opportunities are beginning to emerge
So where are we now? Well, the rising interest rate environment is causing this interest-rate-adjusted earnings yield to go down, meaning that rates have risen more than PE multiples have compressed. See Figure 3 which shows that the Nasdaq 100 Index interest-rate-adjusted earnings yield has fallen from over 2% at the start of the year to just 1.57% in early May 2022. That means these stocks are only yielding 1.57% more than an investor can get on a 10-year Treasury. We know that over time equities offer much better return opportunities than bonds, especially inflation-adjusted returns. If the long-term inflation rate moves toward 3% or even 2%, a 10-year Treasury yielding 3% can’t maintain much, if any purchasing power.
So equities are a more attractive investment, but the big question is, when to increase exposure? If you have a short-term time horizon, say less than 6-12 months, the answer is likely that the equity markets are going to take some time to sort out where inflation and interest rates are going to settle. Other short-term concerns include whether the Federal Reserve, or factors such as the Russia/Ukraine conflict or China lockdown, could inadvertently turn an economic slowdown into an economic contraction unfavorable to equities. On the other hand, if you have a longer time horizon, 3 years or more, then stocks may be starting to look attractive relative to their history and their expected earnings growth, and compared to bonds.
Figure 3 – Interest-Rate-Adjusted Earnings Yield (Inverted NTM PE Ratio minus 10-Year Treasury Bond Yield)
Source: Nasdaq 100, FactSet, as of 5/10/2022.
Figure 4 – Return on Equity & Net Margin: Companies within the S&P 500® & Nasdaq 100 Index have become more profitable over time
Source: FactSet, as of 5/10/2022.
Figure 5 – Companies within the S&P 500® & Nasdaq 100 Index have increased net margins over time
Source: FactSet, as of 5/10/2022.
S&P 500® Index is a widely recognized measure of US stock market performance. It is an unmanaged index of 500 common stocks chosen for market size, liquidity, and industry group representation, among other factors. It also measures the performance of the large-cap segment of the US equities market.
The Nasdaq-100 Index includes 100 of the largest domestic and international non-financial companies listed on the Nasdaq Stock Market based on market capitalization. The Index reflects companies across major industry groups including computer hardware and software, telecommunications, retail/wholesale trade and biotechnology. It does not contain securities of financial companies including investment companies.
The "price to earnings ratio" compares a company's current share price to its per-share earnings. May also be known as the "price multiple" or "earnings multiple". Investors should not base investment decisions on P/E alone, as the denominator (earnings) is based on an accounting measure that is susceptible to forms of manipulation. The quality of a P/E ratio is only as good as the quality of the underlying earnings number.
Indexes are not investments, do not incur fees and expenses and are not professionally managed. It is not possible to invest directly in an index.
Equity securities are volatile and can decline significantly in response to broad market and economic conditions.
Fixed income securities may carry one or more of the following risks: credit, interest rate (as interest rates rise bond prices usually fall), inflation and liquidity.
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.