An investor has a choice, or make that many choices on where to put their money. The most common destinations can be stocks, bonds, real estate, cash and commodities and other real assets. But mostly, investors make a call between investing in stocks vs bonds. If you could buy a bond that pays you 15% you would likely take a pass on stocks earning 5%. On the flipside if bonds are paying you 1% and stocks are earning 3%, you might allocate your money to the highest earner – the stocks. It’s no secret that bond yields are near historic lows. But does that justify moving monies to U.S. stocks that are also earning next to nothing? Do low interest rates justify high stock valuations.
And what do we mean by stock valuations? That is simply a measure of the earnings (profit) that you obtain or own when you purchase a stock or stock market by way of an index ETF. Here’s a related post ..
When you think of investing in stocks, you should think of that as owning a business. And when you own that business – what is your level of profit. How much profit will you make in a year from your $100 investment?
You’ll make $2? $5? $10?
In investment terms that is known as the price to earnings ratio or P/E ratio.
How much profit are you buying?
And that P/E ratio will be calculated based on the the most recent earnings reports. It will be the amount that you are earning today, if the profit level holds. Now certainly, when we buy a company we might also consider the growth rate for the business. A good investment can also be a company that has very low or modest earnings (or no earnings) today, but their growth rate is very impressive. We can make a good guess that they will one day become very profitable.
And make no mistake, earnings matter over the longer term.
The reality today is that the U.S. stock market has been on an incredible run. And that stock market has become very expensive. When we buy many U.S. stocks or a U.S. stock market fund, we are not owning a lot of current earnings. Over the last few months, you would be buying about a 2% earnings yield for the U.S. market. That’s better than the bond yield. Here’s the 10-year U.S. treasury that will often be used as the benchmark for ‘safe’ bond returns.
And now back to the title of this post.
Do low interest rates justify high stock valuations?
Does it make sense to own the stock market because the bond market is ‘worse’? That is the justification or rationale today. At times it goes by the acronym TINA.
There
Is
No
Alternative
And to make things even worse for stocks (and bonds), as I offered in this MoneySense weekly, if we factor in inflation, U.S. stocks are currently delivering a negative real return. Factor in the most recent inflation readings and U.S. stocks don’t earn you a nickel.
And yes, inflation has experienced a recent bump, and earnings are set to recover. Those measures could both reverse the trend of that nasty chart.
This post by Charlie Bilello offers that there is no justification for TINA or perhaps investing at those high valuations.
Do low interest rates justify high valuations?
The killer valuation chart.
The CAPE ratio is a price to earnings valuation tool, but it smooths out the data over time. It takes out a lot of the short term noise and gyrations. It is known to be a truer measure of earnings and earnings health at the points in time.
We can see that the current U.S. stock valuation levels are near that of the dot-com crash era, and just above that of the Great Depression.
When I run real return numbers on money chimp (don’t let the name fool ya, it’s a great resource), I see negative real returns for a decade or more from those peaks. Even from that period top in the mid 1960’s we have a periods of negative returns over 10 through 15 years. Yes, stagflation ate up any stock returns, bond returns, or most any returns save for gold and commodities and commodities stocks.
Don’t forget to click that inflation button on money chimp.
Earnings matter over time.
That earnings matter sounds obvious. But perhaps it is a lesson that many forget.
You should give that Bilello post a read. But I will offer up the conclusion.
If your entire bullish argument is predicated on low interest rates, that alone is not enough. You will need even lower interest rates (and even higher valuations) in the future to experience above-average returns. And if rates were to rise instead of fall (which would not be an unreasonable expectation as we hit all-time lows last year), your entire argument falls apart.
When it comes to equity markets, nothing is as simple as it seems. The narrative of low interest rates serving as a panacea for extremely high valuations is the latest example.
Should you avoid the U.S. stock market?
Of course, the above is not intended to be advice. You can factor in Mr. Bilello’s observations with other research, draw your own conclusions and invest accordingly.
You can trim or avoid U.S. stocks. You can avoid expensive U.S. stocks. An investor does not have to buy ‘the market’. There are U.S. stocks with greater current earnings (value stocks). There are other stock markets that offer much greater earnings, such as Canada, and International markets.
You may choose to buy more of the U.S. stock market funds as there is certainly incredible growth in the many mega tech stocks that drive the market returns. Related post …
Growth will be scarce in the future. We will want to own what is scarce.
In this week’s MoneySense post I looked at the more recent run for Canadian stocks. You’ll find some expert opinions on where to move any Canadian profits if you’re looking to shore up any portfolio holes. The U.S. stock market situation is also addressed.
That post also took a peak at the Canadian banks earnings reports from the week.
With respect to our personal portfolios and U.S. stocks I’ll continue to trim the more growth oriented individual stocks. That’s the wonderful thing with stocks that are on a wonderful run, they present opportunity, even if the reasons for higher stock prices might not make sense. But I will still keep some exposure to U.S. tech growth companies that includes Apple and Microsoft, Texas Instruments and Qualcomm.
I’m moving monies to cash, bonds, gold and other commodities. And yes I’m still investing in bitcoin. That is just ‘another’ portfolio asset. It is now below a 5% weighting, bitcoin is in line for some new money.
And remember if you hold a one ticket portfolio or invest with a Canadian Robo Advisor, your managed portfolio(s) will be rebalanced on your behalf.
All said, being a semi-retirement stage I’m looking to shore up some of the portfolio gains. I want to protect against economic shifts, market corrections, and the potential of real and lasting inflation and currency devaluation.
Early in the accumulation stage, you may approach things with a much different lens .
Thanks for reading. We’ll see you in the comment section. What’s your take, do low interest rates justify high stock valuations?
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Dale
Dale,
If you’re retired, as I am, dividend income and dividend growth overrides price and total returns. Personally I view my pensions and OAS as my fixed income and my dividend paying equity investments as my salary which comes with annual raises (dividend growth). I wouldn’t consider bonds unless they provide a considerably higher paycheque than my equity income, ie; at least 2% higher interest than the ~4.3% overall dividend income I receive. Bonds are called fixed income for a reason. Their interest rates are set in stone so you only get the rate you received when you purchase them. Their value decreases in rising rates. Equity dividend growth, on the other hand, typically matches or equals rising interest rates.