Why the Market Multiple Will be Higher in 2011

Market relationships differ depending upon the time frame.  Right now, higher bond yields are bullish for stocks.  This article explains why.

The most important question for equity investors relates to rising interest rates and the implications for stocks.  Nearly everyone (including us) agrees that long-term rates are moving higher.  That has been the recent move and it implies significant capital losses for those holding long bonds.  Here is a nice analysis of the risk by John Lounsbury.

Several pundits have weighed in on the effect of an interest rate increase.  Let us take a closer look.


On a theoretical basis, lower interest rates are bullish for stocks.  Companies can borrow more cheaply.  The choice for those doing asset allocation tilts toward equities.  The data support the  traditional stock/bond relationship — usually.

But these are not typical times.  Higher interest rates may be consistent with higher stock multiples.  Abnormal Returns covers the topic and also highlights other sites on bond yields.  I want to go beyond the generalized arguments and look to some strong supporting data.

Exceptional Periods

There are circumstances where the relationship is reversed, when higher bond yields are actually correlated with higher stock prices.  Several commentators have suggested that this might be such a time, but I always like to look at the data.

We have seen this before….

We had a similar situation in 2004.  A top analyst from a major firm, drawing upon the help of his entire team, developed a regression model relating bond and stock prices.  The research team facilitated their analysis by throwing out data that did not fit their thesis.  As usual, it was a mistake to begin the research with a pre-destined conclusion in mind.

This research was actually one of the things that inspired me to start blogging.  I figured that if the proprietary research by big firms has such major flaws, there had to be room for people who had strong and discplined methods.  You can check out my old article (one of my favorites) by looking for the initial reader challenge here (no one solved the problem then, and you won't now) or the full exposure of the big firm's blunder here

If you want to see the entire logic — and you should — check out the full article.  It required more hours of research than any other piece I have ever done.  Meanwhile, here is the key finding:

The relationship between stocks and bonds is curvilinear.  In the "normal" range of interest rates, stocks and bonds trade as expected.  When interest rates fall to a an extremely low level, the relationship breaks down.  Why?  The very low interest rates reflect deflation concerns and extreme skepticism about earnings from stocks.

Here is the relationship:

Bonds and Stocks

The historical data show the relationship between stocks and bonds.  The chart highlights two distinct anamolous periods.  Please note that I am not just throwing out data.  Analysts (and readers) are free to draw whatever conclusions seem appropriate.  The chart facilitates your analysis rather than forcing you into a conclusion.  If you read the entire article you will see five different views of the same data.  It shows the difficulty of the task.

My Conclusion

The evidence shows a long-term relationship between the forward earnings yield and bond yields.  This is what we would expect.

When bond yields get very low, the relationship breaks down.  This also makes sense.  Yields have been very low twice in the last decade, both times when there were extreme deflation fears.  Under those circumstances there is intense skepticism about future earnings forecasts, so the multiple is low.

Investment Conclusion

We are currently at the unusual tipping point in the relationship.  The emerging consensus about improving economic prospects is having two effects:  higher long-term bond yields and more confidence in earnings.

The implication is that stocks will get a higher multiple in 2011 as confidence improves.  This is not merely speculation, but a conclusion based upon the data cited.

If the market were to embrace this traditional relationship, the forward earnings multiple would be in the 20's.  This suggests an S&P 500 value that is 50% higher (or more) than current levels.

I am not making this as a prediction, since the climate of fear has cast a negative spell upon earnings.  Who knows how long this will last?  I have often suggested that low market multiples are the best single gauge of investor sentiment.  I do predict that the path of least resistance is higher, and it could be much higher.

The summary:

Higher bond yields imply more economic confidence and a higher stock multiple.

You heard it here first, including when I highlighted the topic in the gloomy days of August.


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  • Paul Nunes December 10, 2010  

    I enjoyed and was enlightened by your articles on this! Nicely done and thank you for the effort. I received a copy of the UBS 2011 strategy report and I will read with your points in mund.

  • oldprof December 10, 2010  

    Paul — I haven’t yet seen the UBS 2011 report, but I’ll read it with interest.
    Thanks for your encouragement:)

  • wsm December 12, 2010  

    I agree with your conclusion that higher bond yields in the coming year would indeed be a positive for stocks. I just don’t think we are going to get those higher yields. I think that the deflationary forces are much too strong for the failed reflationary strategies being pursued.