The Relationship Between Interest Rates And Stock Market Valuations

Source: Reuters.com

It is a generally accepted rule that the interest rates and the stock market move in opposite direction. The reasoning behind this is that a lower interest rate is good for businesses at large.

Therefore the interest rates could be considered a leading indicator for company performance. In such a case, this impact should result in an immediate PE expansion, as the eventual benefit of improved earnings is going to take a while to materialize.

We can see this phenomenon in an empirical analysis of S&P PE and the 10- yr Treasury rates for the last 50 years. The correlation between these two variables is negative 0.57, indicating an inverse relationship. By running a regression between these two variables, we arrive at the below relationship

P/E = 26.87- (1.37 X Treasury rate)

This can partly explain the high valuations accorded to the market in a low-interest rate scenario such as now. The gradual lowering of interest rates since the 1980s has contributed to the stupendous performance of some of the fund managers in this period. Given that there is not a lot of room to further reduce the interest rates, the performance of the fund managers on an average will most likely be less stellar in the coming decades. It would be more and more difficult in the future to generate the 20% plus annual returns, generated by some of the best fund managers in the past.

*Using the regression model, the forecasted PE as of May 31, 2018 is 23.06. The actual market PE was 24.83, indicating an over valuation beyond the multiple forecasted by the model.

* A similar analysis of the Indian stock market did not yield any meaningful relationship.

*For the regression model, the data points between Oct 08-Oct 09 were ignored, as they were considered outliers.