What Raised the S&P 500 Price-Earnings Ratio?
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‘September 7, 2020,
‘Alan Reynolds
~ September 7, 2020 Reading Time: 5 minutesStock prices fell sharply before the Labor Day weekend, following an astonishing rise from
March lows. Information technology stocks in the S&P 500 fell from a peak of 2128.1 on
September 2 to 2046.27 by 2:30 two days later. But that was just the equivalent of losing
two weeks of gain:
Momentum trading had surely pushed some high fliers into frothy territory, so a correction
s correct. But skeptics and short traders claim the market as a whole still remains totally
disconnected from “fundamentals.”
Other commentators suggested investors were suddenly terrified that Congress had not yet
agreed to borrow and give away trillions more to “stimulate” something or other. “If we do
not get another stimulus aid package in time,” warns Forbes columnist Naeem Aslam, “the
economic recovery will remain fragile"(though it's growing at a 26.2% to 29.6% rate). A
recent Wall Street Journal story likewise warned that “failure by Congress to deliver
additional relief measures for American consumers and businesses could weigh on market
sentiment.”
Yet the disappearance of the “stimulus package” is old news. Most of it began and ended in
April when nearly everyone received a $1,200 check, and PPP loans soon dried up. The
extra $600 of weekly unemployment benefits ended July 31. Yet stocks were particularly
strong in August. The rapid winding down of stimulus schemes from May to July was
essentially irrelevant compared to April's all-important news that 28 states announced that
they would be reopening from April 20 to May 4, soon followed by most othersThis brings us back to the more serious question — namely, the alleged disconnect between
S&P 500 stock prices and “fundamentals.” This often boils down to the fact that stock prices
seem high relative to past earnings. But the price/earnings (P/E) ratio can’t be understood
without looking at bond yields. That is because a lower interest rate increases the
discounted present value of future earnings.
The argument for stocks being greatly “overvalued” rests on the fact that the trailing P/E
ratio rose significantly from May 1 to September 1. On January 1, the P/E ratio was 24.21 —
about the same as two years before (24.87). Even after Covid-19 and lockdowns crushed the
economy, the P/E ratio was still 23.74 on April 1. Stock prices and earnings had both
collapsed in syne. The P/E ratio was 25.10 on May 1 after the Fed funds rate fell to nil and
the $1,200 checks and PPP loans peaked. It then rose to 26.69 on June 1, 27.57 on July 1,
28.31 on August 1 and 30.32 on September 1.
Using the first of the month as a rough gauge of trends, S&P 500 stock prices have been
rising even faster than these firms’ average earnings over the preceding 12 months. This
may appear to suggest that stocks grew overvalued relative to the growth of earnings, but
there are two reasons to question that conclusion. The first reason is that we need to
compare these historically high P/E ratios with historically low bond yields. The second is
that we need to realize that trailing earnings over the past 12 months currently translate
into a ridiculously low denominator for the P/E ratio. Average earnings over the past 12
months include some of the worst in U.S. history — notably, March and April.
To compare both P/E multiples and bond yields over time it is illuminating to simply invert
the P/E ratio in order to create an E/P ratio. This E/P ratio is called the “earnings yield.”
The earnings yield is simply the inverse of the trailing price-earnings (P/E) ratio. That is,
the earnings yield shows earnings per share for the last twelve months divided by the
current market price per share.Figure.
‘S&P 500 REPORTED EARNINGS YIELD"
vs US TREASURY 10-YEAR BOND YIELD
‘SBP 500 Earrings Yield (2.41)
US Treasury 10-Year Yield
(percent) (069)
~ S4P sco rqpate eamiags 2s pace’ of quarry serge SP 50nd. 1.2008 capped
Share Stand Por sand federal Reserve Boe
ofaegatve ve.
Ed Yardeni depicts the earnings yield as a blue line in the graph reproduced here (his Figure
8). The 10-year Treasury bond yield is shown in red. Obviously they generally rise and fall
together, sometimes with the earnings ratio in the lead.
In 1997, Yardeni dubbed the relationship between bond and earnings yields “The Fed
Curve.” That was because the Greenspan Fed had just alluded to it. Later, I modestly
renamed it “The Reynolds Model” because I unveiled it in a March 21, 1991 memo to my
consulting firm’s institutional investors. Alan Greenspan might have seen it, since he was on
my comp list after because we worked together on President Reagan’s transition team.
Since the earnings yield is the P/E ratio inverted, the graph shows that the P/E ratio falls
(the blue line rises) when inflation speeds up, particularly the decade after the gold window
closed on August 16, 1971. Conversely, the earnings yield falls and the P/E ratio rises when
inflation and bond yields fall. If the Fed were to sueceed in getting inflation significantly
above 2%, they would also sueceed in pushing the P/E ratio down, Chairman Powell
announcing the Fed’s hope for higher inflation on August 27 was risky news for stocks, and
for bonds. The 10-year bond yield rose from 0.65% on August 24 to 0.72% on September 4,
which may partly explain the observed decline in the P/E ratio.‘What happened to stock prices in recent months is quite consistent with the
Yardeni/Reynolds Model: The higher P/E ratio (lower E/P ratio) can be explained by the
10-year bond yield dropping from 1.88% on Jan 2 to 1.1% by March 2 and then 0.62% on
April 1 before rising only very recently to 0.72%. The Fed funds rate deserves no credit for
lower bond yields (worldwide), because the Fed reluctantly followed the market down —
keeping the fed funds rate at 0.6% in March while the 3-month bill rate fell to 0.29%.
The Federal Reserve can certainly crash the market (e.g., the double-dip recessions of 1980-
82), but milder forms of Fed activism rarely explain bond yields or stock prices. The 10-year
bond yield has at times risen 3.5 to 4 percentage points above the Fed funds rate, as in 1992,
2001-04 and 2010. Also, the S&P 500 stock index hovered at or below 2000 the last time
the Fed kept the funds rate near zero in 2014-15, then rose 46% by July 2019 even as the
Fed raised the funds target ten times to 2.5%.
Yardeni’s graph leaves no room for fiscal stimulus as an explanation for the stock market's
perfectly predictable rebound after State lockdowns began to be relaxed. Earnings rose
because closed businesses were permitted to open. And the P/E ratio rose because the
earnings yield always falls when bond yields fall.
Some see today’s high P/E as prima facie proof of a speculative bubble. But the fact that
stock prices may look high relative to earnings over the past 12 months (which include an
unprecedented GDP contraction) does not mean they are high relative to the next 12
months.
For those who find stock price gains inexplicable and therefore terrifying, the Yardeni-
Reynolds Model offers a purely empirical explanation of a seemingly high trailing P/E ratio
— extremely low global inflation and bond yields combined with an artificially low P/E
denominator of past earnings that includes the terrible second quarter of 2020.
READ MORE
Alan Reynolds
Economist Alan Reynolds is a senior fellow at the Cato Institute, and former vice president
of the First National Bank of Chicago. He served as research director with Jack Kemp's
1995-96 Tax Reform Commission, and with Larry Kudlow and Alan Greenspan as a
member of President Reagan's 1981 transition team. He is a former columnist with Forbes,
Reason, and Creators Syndicate. He is also a past member of the Blue Chip and Wall Street
Journal forecasters.
Author of the 2006 book Income and Wealth, Alan Reynolds has written for countless
publications since 1971, including the Wall Street Journal, New York Times, Harvard
Business Review, The Public Interest, National Review, Regulation and The Cato Journal.Get notified of new articles from Alan Reynolds and
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