Low P/Es are possible when interest rates are low
There is something deeply satisfying about seeing an investment theory
splatter on the windshield of the market. The road is littered with
the carcasses of past investment theories.
But today let's look at the notion that Shiller's P/E should be high
when long-term interest rates are low.
Before driving into the details it's good to review what Professor
Robert Shiller's P/E ratio is all about. At first glance the ratio
looks a lot like the familiar price-to-earnings ratio. But while the
standard P/E formula divides a stock's price by its earnings per share
over the last year, Prof. Shiller's method divides the stock's price
by its average inflation-adjusted earnings over the last 10 years. He
calls the result a cyclically adjusted P/E ratio, or CAPE.
In contrast to a standard P/E ratio, CAPE gives you a much better
picture of how prices stack up against a stock's typical earnings
power. It smoothes out temporary gains or losses.
CAPE is particularly interesting when you apply it to the entire
market, which Prof. Shiller does for the S&P 500. As things stand the
market's ratio is fairly high at 20.5 when compared to its historical
average of 16.4. Bears use the ratio as evidence that the S&P 500 is
overvalued by roughly 20 per cent, all else being equal.
However, an esteemed colleague recently pointed out that Shiller's P/E
is impacted by interest rates and made the case that the ratio should
be high when long-term interest rates are low. Problem is, practice
tells a different tale.
It turns out the relationship between Shiller's P/E and interest rates
isn't straightforwardly linear. It has a bit of a hump, which you can
see in the accompanying graph that displays how average CAPEs vary by
interest rate.
[larger version]
You'll immediately notice that low interest rate environments haven't
automatically resulted in high P/Es even though high rates have
historically led to P/Es. Instead, bulls who dream of bubbles and high
P/Es should want interest rates to be somewhere in the middle.
Let's focus on times when interest rates are low. The second graph
shows just such a period. It covers the two decades from 1935 to 1955,
which saw a wide range of economic and geopolitical conditions.
[larger version]
As you can see, it is entirely possible for the market to trade at low
ratios when rates are low. If anything the recent ratios have been
high compared to past levels.
If you just consider times when interest rates have dipped below 3 per
cent, you'll find that Shiller's P/E has averaged 13.6.
As a result, history provides even more meat for the bears because it
bolsters their arguments that stocks are pricey. A decline of about 34
per cent would be needed to bring Shiller's P/E back to its historic
norms after adjusting for interest rates, all else being equal.
But there is a fair amount of variability in the data, which holds out
a slender reed of hope for the bulls that this time may be different.
First published in the Globe and Mail, June 2 2012.
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