Thursday, February 4, 2010

Hussman Weekly Market Comment from May 21, 2007: How Much Do Interest Rates Affect the Fair Value of Stocks?

In recent months, I've used a wide variety of analytical methods (discounted cash flows, normalized earnings, price/peak earnings calculations, etc) to show that stocks are currently priced to deliver unusually poor long-term returns – stated simply, the U.S. stock market is more overvalued than at any point in history except during the late 1990's bubble. In general, the methods I use emphasize that stocks are a claim on some stream of cash flows that will be delivered to investors over time. To estimate fair value, it is crucial to normalize earnings (rather than using “forward operating earnings” without correcting for the level of profit margins or the position of earnings within the economic cycle, as Wall Street seems eager to do here).

But what about interest rates? Sure, S&P 500 earnings are pushing along the very top of the 6% long-term growth trend that has repeatedly connected earnings peaks across economic cycles over the past century, and the S&P 500 currently trades at over 18 times those record earnings. Sure, when earnings have been similarly elevated in the past, the P/E multiple on those “top of channel” earnings has averaged only about 10. Sure, on normalized profit margins, the S&P 500 P/E would be about 25. Sure, profit margins have repeatedly experienced mean-reverting cycles over time. But this time it's different! After all, the current interest rate on the 10-year Treasury bond is a whole 1.4% below the average level of 10-year Treasury yields since 1950, and the year-over-year inflation rate is currently a whole 1.6% below the average inflation rate since 1950. Doesn't this mean that stocks deserve to be valued 60-80% higher than the historical norms?

If you watch CNBC for a few minutes, you'll immediately hear some analyst claim that stocks are cheap because the “forward earnings yield” on the S&P 500 is higher than the 10-year Treasury yield. The next analyst will just say that “stocks look cheap compared with bonds.” The next will offer some strange convolution of the so-called "Fed Model," like “Sure, P/E multiples are above average, but bonds are trading at a P/E of 21.” After a short break from the monotony by some kind of circus clown playing with horns and buzzers, another analyst then comes on saying how the firm's “valuation model” (which is driven by forward operating earnings and interest rates) implies that stocks are 20% undervalued.

Wall Street is presently managing trillions of dollars of other people's money on the basis of a single toy model, originally discovered in a packet at the bottom of a Cracker Jack box. Despite the superficial appearance of being some sort of discounting model (with the earnings yield in the numerator and the interest rate in the denominator), the "Fed Model" doesn't actually map into any reasonable model of discounted cash flow valuation without making odd and counter-factual assumptions about the relationship between growth, payouts, interest rates, and risk premiums.

The Fed Model asserts that earnings yields and Treasury yields have a 1-to-1 relationship, that stocks are undervalued anytime the earnings yield on the S&P 500 is higher than the 10-year Treasury yield, and that the gap between earnings yields and interest rates is the prime determinant of subsequent market returns.

Proponents of the Fed Model ignore pre-1980 data entirely. That period since 1980 on the above chart is the entire basis for the analysis. In effect, the Fed Model looks at the decline in earnings yields since 1980, and loads the entire explanation on the decline in interest rates. What actually happened is that you had a second factor – the move from extreme undervaluation (abnormally high earnings yields) to extreme overvaluation (abnormally low earnings yields). The true “fair value” relationship between earnings yields and interest rates is nothing close to 1-for-1.


Again, it's perfectly valid to expect interest rates to affect stock market valuations, but 10-year Treasury bonds have durations that are far too short to assume anything remotely close to a 1-to-1 relationship with earnings yields.

In short, interest rates affect “justified” stock valuations when 1) the interest rate changes do not pass through to equal changes in earnings growth, and either; 2) the change in interest rates can be expected to be permanent, rather than damping out over time, or; 3) the change in interest rates is based on a security with the same effective duration as stocks. Presently, stocks are so overvalued that you would have to use a 50-year zero-coupon bond (even a 30-year Treasury bond has a duration of only about 14 years). If such a security existed, you can be sure it would have a higher and far less volatile yield than a 10-year Treasury.

The historical data simply do not support the notion that fluctuations the 10-year Treasury yield should cause wide swings in “justified” stock valuations.

But that doesn't mean that interest rate fluctuations aren't important…

The importance of trends in interest rates

When we think about the effect of interest rates on the stock market, we have to make a major distinction between the level of interest rates, and the trend of interest rates.

What we've established so far is only that the level of interest rates (at least on the basis of short or intermediate term bonds) does not justify large changes in the “fair” multiple applied to stocks. Within a wide range of movement, changes in the level of interest rates normally warrant only one or two points of variation in “fair” P/E multiples. The remainder of the actual fluctuations in P/E multiples reflect changes in the long-term attractiveness of stocks.

Having addressed the question of "fair value," we can ask a different question – what happens when stocks become significantly overvalued or undervalued? Regardless of the level of interest rates, does the trend of interest rates affect how quickly valuations revert toward more normal levels? The answer here is a resounding “yes.”

Note the distinction. Interest rate levels on conventional short- or intermediate-term Treasury bonds don't have a huge effect on the “fair” or “justified” value of stocks, but when stocks are far from fair value, interest rate trends (regardless of the level) do affect the speed at which stocks revert back toward normal valuations.


Capitulating at the highs

Of course, there are numerous ways to improve the classification of market conditions by including additional relevant factors. The problem is that even an approach that performs remarkably well on a total return and risk-adjusted basis over the long-term, and even over repeated market cycles, may produce fairly dull returns over extended periods shorter than a full market cycle. At times like the present (as in 1999 and 2000) when the market advances despite conditions that have historically produced poor returns, it is easy to capitulate at the highs, and buy into a market that seems to be “running away.”

It may help to realize that if an investor had sold stocks and moved to Treasury bills in September 1996, missing the last 4 years of the bull market advance to the 2000 peak (during which time the S&P 500 gained an additional 120%), that investor would still have performed better than a buy-and-hold on the S&P 500 by the time that the subsequent bear market was complete in 2002. I cannot emphasize enough how profoundly a large loss can damage long-term returns. Bear markets routinely erase more than half of the preceding bull market advance, but that's not easy to remember when every marginal new high is celebrated as if there can't possibly be any end in sight.

As always, the objective is to accept risk in conditions that have historically produced a strong return/risk profile on average, and to avoid, hedge or diversify away risk in conditions that have historically produced a poor return/risk profile on average. That phrase “on average” is what separates us from market timers. A market timer believes that the next draw out of a hat can be predicted in advance. We just believe there are different hats, and once you identify the hat (the “Market Climate”), the best one can know is the average return/risk profile of the returns that will be drawn from that hat. It is not possible to tell whether the next short-term return produced by the market will be positive or negative.