Equity markets have been on a rapid upward trajectory over the past two years, lifting index-level price/earnings (P/E) multiples (and other valuation metrics) to a range unseen in over two decades. However, a low-rate environment has typically justified higher stock market valuations than when rates have been unusually high.
While the valuation range has been broad, the average P/E ratio for the S&P 500 index has been near 20 when 10-year Treasury yields have been below 6% over the past 50 years. In contrast, when rates have been above the 6% threshold, that average has been considerably lower — around 14 times earnings. This dynamic intuitively makes sense, as lower rates make it easier and less expensive for businesses to borrow and raise capital, while higher rates tend to restrict business activity. In addition, higher interest rates incentivize investors to demand higher expected returns from stocks to justify taking on the additional risk that accompanies moving beyond bonds to stocks, pushing their valuations lower.
Treasury yields have risen sharply in recent years, but still aren’t unusually high relative to history. U.S. large-cap equity valuations are elevated, but the rate environment helps to justify index-level price multiples that are higher than their long-term average. In addition, as we discuss in our accompanying piece, the interest rate environment isn’t the only factor supporting higher valuation multiples, but it’s one that shouldn’t be overlooked.
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Plante Moran Financial Advisors (PMFA) publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the companies or sectors mentioned herein may not be appropriate for you. You should consult a representative from PMFA for investment advice regarding your own situation.
