Fundamental Relationships have Changed in QE’s Wake
“When the facts change, I change my mind. What do you do, sir?”
— Attributed to John Maynard Keynes (1883-1946)
I read a lot of market commentary. There are a lot of doomsayers out there. While I can’t argue with the fact that valuations are higher than they were at the market lows in 2009, the calls for a calamitous decline based on valuation seem overblown. Valuation tends not to be a good predictor of bear markets. To be sure, there are risks to the equity markets. But, there are always risks. The quote above is à propos because (1) though it is attributed to Keynes, there is no concrete evidence of him saying it;1 and (2) it speaks to our inherent intellectual aversion to adapting to change.
There is one trend in particular that I have been watching: the relationship between bond yields and equity valuations. Traditionally, there is a somewhat positive relationship between the two. The first chart below plots the relationship between the Earnings-to-Price (EP) ratio (vertical axis) with 10 Year U.S. Treasury yields from 1973 to 2008 (horizontal axis), just before the period of massive monetary stimulus that we live in today. Earnings-to-Price is just an inverted PE ratio, so the higher the EP ratio, the cheaper the market.
Notice the upward sloping relationship, which suggests that higher bond yields are typically associated with cheaper equity valuations. Conversely, lower yields are associated with higher equity valuations. Without getting into corporate finance theory, the idea is that low interest rates decrease interest burdens for corporations, thus, increasing profit margins and boosting earnings.
Relationship Between Earnings Yield and Bond Yields (1973–2008)
It is not uncommon for this relationship to change over time. Breaking down the above chart by decade, the steepness of the relationship between equity and bond yields does change.
Relationship Between Earnings Yield and Bond Yields (Decades)
In the 1970s, as inflation was raging, the upward slope of the relationship was much steeper. As rates and inflation have come down in successive decades, the slope has gotten flatter. But, that relationship remained upward sloping for four decades.
Enter quantitative easing (QE), and the relationship inverted. After the crisis, lower yields have been associated with cheaper equity valuation, the opposite of the historical precedent. This helps explain why markets have rallied as various monetary stimulus has been extended.
Relationship Between Earnings Yield and Bond Yields (Before/after — version 1)
Clearly, QE’s goal of distorting interest rates lower has been achieved. The evidence above confirms that bond yields are lower than they otherwise would have been without QE. Based on the longer-term historical relationship, without a QE kicker, the 10 Year Treasury would yield 4.62% — 3% higher than its current level. The question really becomes, is this a permanent change? If not, when will it revert.
Turns out, it’s already reverted, and the restoration of the historical trend aligns pretty well with the tapering action in late 2013. Carving out the period of most aggressive monetary policy action, the five years from 2008 to 2013, the positive relationship has re-established itself in the post-crisis era, shown here:
Relationship Between Earnings Yield and Bond Yields (Before/after — version 2)
Relationships change over time. We live in strange times when four-decades-old fundamental relationships are turned on their head. Yet, they seem to sort themselves out. We can’t rule out a downturn in the equity markets. There will be another one… some day. But let’s give markets some time to soothe their wounds and central banks to get their houses in order before banking on the next Apocalypse.