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Is the stock market too high on low rates?

March 12, 2014

| MoneyRates.com Senior Financial Analyst, CFA

In the last week of February, Federal Reserve Chair Janet Yellen acknowledged concern over the strength of the economy in testimony before the Senate Banking Committee. If you assumed that one of the nation's top economic officials expressing doubts about economic growth would be unsettling to the stock market, you would be wrong.

Stocks instead rallied on news of Yellen's testimony -- such is the upside-down logic of stock prices and interest rates.

In love with low interest rates

The reason the stock market liked Yellen's comments was that it raised the possibility that the Fed would slow the tapering of its quantitative easing program, thereby holding long-term interest rates down for a while longer.

The market has two reasons to applaud low interest rates:

  1. Low rates can be stimulative. Low interest rates make it cheaper to borrow money, and thus easier to spend. However, whether Fed policy has succeeded in stimulating the economy is a matter of some debate. The Bureau of Economic Advisors recently downgraded its estimate of GDP growth in the fourth quarter of 2013 to a real annual rate of 2.4 percent. This is quite a drop from the original estimate of 3.2 percent, and an even bigger plunge from the third quarter's growth rate of 4.1 percent. Once again, the economy has failed to sustain any momentum.
  2. Low rates make stocks look good by comparison. Technically, this has to do with using a lower interest rate to discount the value of future earnings. More intuitively, any investor can relate to the fact that low rates drive people toward the stock market. Savings account rates are near zero, and Treasury bond yields are less than 4 percent. Among conventional asset classes, stocks are the only option offering a solid chance for growth and beating inflation.

Yield comparison

The relative attractiveness of stocks is illustrated when you look at stocks in terms of yield. The dividend yield of the S&P 500 is about 2 percent -- certainly much better savings account rates and even most long-term CD rates, though not as high as long bond yields. However, since stocks do not pay out all of their earnings, stock analysts generally look at earnings yield (essentially, the inverse of the price-to-earnings ratio) more than dividend yield in valuing stocks.

Currently, the earnings yield on stocks is 5.7 percent, much higher than bank rates or bond yields. At the end of the 1990s, the earnings yield on stocks was 3.3 percent. At the time, 30-year Treasury yields were about 6.4 percent; today Treasury yields are down around 3.8 percent.

So, when you add all this up, even though stock prices are higher now than they were at the end of the 1990s, earnings have grown even more, pushing the earnings yield up. Meanwhile, bond yields have come way down, making that earnings yield even more attractive by comparison.

The only problem is, a stock rally that is overly dependent on low interest rates could paint itself into a corner. A strong economy would drive bond yields up, causing the earnings yield vs. bond yield comparison to suffer. A weak economy could erode the earnings yield, and since bond yields do not have much further to fall, the earnings yield vs. bond yield comparison would suffer again.

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