Views from the Floor - The End of TINA?

Are equities actually expensive and are rates really that high?

In recent days, we have seen US and European stocks fall while yields on US government debt have neared their highest levels since 2007.1 These are moves which have, in part, been fuelled by concerns that the Federal Reserve will likely continue to raise interest rates.

Higher rates also raise the question as to whether we are now at the end of TINA, or There Is No Alternative. The acronym has become common parlance in the investment world over the last decade as bonds and cash offered investors little to no yield and those searching for returns had little option other than to invest in equities.

A low-rate environment allowed for higher equity valuations, both because they are competing assets (low rates make equity yields attractive) and because discount rates tend to play a significant role in equity valuations. In the past two years, however, we have seen interest rates globally rise materially as central banks have sought to battle inflation. Although the impact on the long end of the curve has been somewhat muted, we have seen 10-year yields in the US rise from approximately 1.5% to about 4.3% at the time of writing.

Digging into the historical data, over the last 60 years in the US, there has been a positive relationship between nominal yields and the earnings yield of the S&P 500 Index, with an R-squared of 36%, as shown in Figure 1.

Figure 1. S&P Earnings Yield Versus US Treasury Nominal 10-Year Yield

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Source: Man Numeric. Covers period from 31 January 1962 to 30 June 2023.

The 10-year yield today would imply an expected earnings yield of 5.7%, or a price-to-earnings multiple of 17.5x, yet the S&P 500 currently trades at approximately 20x. On this basis, the S&P 500 does appear a little expensive, though it is worth nothing that if the FAANG stocks are excluded, the multiple decreases to close to 17x. A further explanation for the 10% overvaluation might be that we are near trough earnings, and that they are due to rebound, though we do not believe this to be the case. It could also be that artificial intelligence will significantly boost earnings in the future, which we think is plausible but remains to be seen.

If rates on the long end do rise further from here, we expect this to put pressure on equity valuations. It’s also worth noting that although the current 10-year yield might seem high to current market participants, being close to its highest level in 16 years, this is actually still at the very low end of the 1962-2007 range.

 

(With contributions from Dan Taylor, CIO of Man Numeric).

1. Treasury yields near 16-year high as bond market shifts from low-rate era

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