Three Things About Higher Rates
4% TREASURY YIELDS – GOOD OR BAD?
Yields on U.S. Treasury bonds are at their highest level in about 15 years. Three questions came to mind:
Do higher rates make bonds a better diversifier?
What’s the “right” price for stocks?
Can stocks still perform well from here?
We looked at some of the data since 2000 to try to provide a little perspective. Specifically, we were interested in periods where 10-year U.S. Treasuries yielded between 4% and 5%.
That left us looking at 2001 through 2007, for the most part.
Before going any further, it may help to remember the 2000s represented one of the worst 10-year periods for U.S. stocks on record. It included two nasty bear markets. The tech bubble burst from 2000 to 2002, with the S&P 500 falling 47% and the NASDAQ dropping nearly 80%. Five years later, the global financial crisis led to a 56% decline in the S&P 500 from late 2007 through early 2009. These two declines left lasting impressions on investors. Still, a look at the data my provide some helpful context as we think about why could lie ahead.
DID BONDS JUST BECOME A BETTER DIVERSIFIER?
Maybe!
When we (Divvi) think about bonds, we want them to move differently than stocks. At the very least, we hope they aren’t moving in the same direction all the time.
2022 is a great example of when high quality bonds like U.S. Treasuries did not provide much diversification benefit to owning stocks. Inflation and interest rates rose, punishing bond prices right along with stocks. We talked about this previously, in our annual letter sent out at the beginning of the year.
However, in other periods, bonds have provided a nice ballast to stocks during periods of volatility. Not all bonds are created equal, of course. Corporate bonds, both high quality (IG) and high yield (HY), have historically moved in a similar direction as stocks. Treasuries, on the other hand, have had a negative correlation over the last 23 years. Look at the chart below.
Zooming in a little closer on Treasury bonds, here is a chart showing their correlation to the S&P 500 following periods where the 10-year was yielding between 4% and 5%. From a diversification perspective, we prefer these numbers to be below 0%, in the red area of the chart.
Treasuries appear to check this box.
Looking at the portfolio in whole, high quality bonds like U.S. Treasuries should be in a better position today to offset equity risks compared to the recent past.
WHAT IS THE RIGHT PRICE FOR STOCKS?
I’m talking about the price-to-earnings multiple, specifically. This matters because stock returns are a function of:
Dividends
Earnings growth
Multiple expansion/contraction
Expanding multiples mean investors are willing to pay more for earnings, for instance, and this serves as a tailwind for stock returns. Contracting multiples have the opposite, creating a headwind for stock investors.
The right price is clearly subjective, but one rule of thumb to help estimate a fair P/E ratio is called the rule of 20. It suggests the fair P/E multiple for stocks is 20 minus the rate of inflation.
As of July 31, the current year-over-year inflation rate is 3.2%. That would suggest the fair P/E multiple for U.S. stocks to be about 17x earnings.
The current P/E ratio is about 25x using earnings from the last 12 months, or about 20x using earnings estimates for the next 12 months.
Another way to think about P/E multiples is by looking at the level of interest rates. Theoretically, higher rates could give investors more options (via bonds) and lower rates push investors into riskier assets. Historically, this has been true as interest rates and P/E multiples have had an inverse relationship.
Since 2000, the median forward P/E ratio for the S&P 500 when 10-year Treasury yields have been between 4% and 5% is 16.1. Again, the P/E today is about 20x.
Viewed through either of these lenses, stocks appear a bit expensive.
Which takes me to my third question…
IS IT A BAD TIME TO OWN STOCKS?
I think the answer largely depends on your time frame. Odds still appear to favor the long-term optimists.
Short-term stock returns, on the other hand, are notoriously difficult to predict. Look at the table below, starting with the 1-year column in the Returns section. The returns columns show total returns for the S&P 500 over varying lengths of time. The difference between the best and worst 1-year return was a whopping 66%!
While each starting point in our sample had one thing in common – 10-year U.S. Treasury yields between 4% and 5% - differences certainly remained. And the environment today is unique, as well.
Regardless of whether circumstances make you feel excited or nervous about investing in stocks, keeping a longer-term perspective can help. Yes, we have gone through long stretches with underwhelming performance. I suspect few people would be happy with a 14% return over 10 years (the worst return in the 10-year column). Still, the median return over 15 years, even with those two nasty bear markets in our sample, was 267%, or 9% annualized.
Returns columns display S&P 500 total returns. Correlation columns show 3- and 5-year correlation of S&P 500 returns to Bloomberg US Treasury Index total returns. % Pos shows the percentage of periods in which the data point is above zero. % Neg shows the percentage of periods in which the data point is below zero.
SUMMARY
Interest rates on bonds haven’t been this high in about 15 years. Whether you consider this to be good or bad news may depend on your perspective. Higher rates generally offer a better starting point for bond investors, and high-quality bonds may be in a better position to offset other risks in your portfolio. Stock investors traditionally have been willing to pay less (in terms of P/E multiples, for example) for expected earnings as interest rates rise, which can put pressure on stock returns.
Regardless, history has seemed to reward stock owners over the long term, even in periods characterized by higher interest rates. We continue to encourage people to align goals with investment strategies that don’t depend on a singular economic outcome to result in success.
Interested in talking more? Email me at eric@divviwealth.com or set up time with the Divvi team to continue the conversations.
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