Big article on Marketwatch today about how “young and dumb traders” were driving the market rally, which current has the indices within spitting distance of all time highs despite the COVID reduced recession, and has the market extremely overpriced (meaning, a forward P/E of 22–24, when historically a P/E of 16 is considered to be fully valued).

(I’ll link to the story below, so as not to distract anyone.) :-)

I had to wonder for a moment if that’s actually true or not. Not the part of young and dumb traders, but if the market is actually overpriced.

The traditional market mean of 16–17 is just that; an average. But prices (and earnings) are affected by certain other quantitative variables which are set independently, the most notable of which are interest rates. When the Fed wants to stimulate the economy, which drives earnings up, they lower interest rates. When they want to keep the economy from overheating and crashing, they raise the rates, which puts the brakes on earnings. Prices, of course, move accordingly.

So, riddle me this: If we take it as Truth From On High that lower interest rates will boost earnings, and higher interest rates depress earnings, then shouldn’t the definition of “fully valued” fluctuate inversely with interest rates?

I’m still thinking this through and may extend this article later on after running numbers in a pro analysis tool, but here’s a rough cut of what I’m thinking about:

From 1963 to 2010, the average forward P/E of the market was 18.5. During that period, the average 10-year T-bill rate was 6.88%.** **(Seems surreal, doesn’t it?)

From 2011 to 2019, after the Fed entered into their low-rate policy after the meltdown and subsequently returned to that policy due to COVID, the average forward P/E of the market has been 20.5 (or, 10% higher) but the average 10-year T-bill rate has been 2.31% over that period of time (or, a third of its prior average).

Now, I’m not suggesting that the inverse correlation between the two is perfect and fully predictable — that equation (P/E 61) puts the S&P at 10,300, basically requiring all the stocks in the index to triple in prices. As nice as that would be….unlikely.

However, what I AM suggesting is that at an average interest rate of 2.31% (also, note that the current rate is a miniscule .89%) that a fully priced market is going to have a higher P/E than its historic average.

As I said, I may play around with these correlations a bit and see if there’s any way to predict what affect each 1% of interest rate has on the equity indices.

But the takeaway here is that I am not sure that P/E 22–24 is all that scary, when interest rates are < 1%.

Be curious what other thoughts folks have. Link to the story that got me thinking follows: