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The reasons for the 30%+ market drop in late March 2020 seemed obvious at the time, after all, we had a global pandemic shutting down the global economy. Though what’s driving my clients and investors crazy is figuring out how and why the major stock market indexes have begun recovering so quickly.
I can come up with several answers, but I will go in-depth with one of the less obvious, most interesting ones.
The first several have to do with money flooding the US and global economy. For this column, I’ll focus on the US. Simply put, the sheer amount of spending (money sent into the economy) and liquidity (the buying of bonds and other instruments by the Trillions) have both helped offset some of the missing funds flowing through the economy, and stabilized the financial system.
Within these justifications for a market rebound was a nuance to the Fed’s actions that I believe caused a significant portion of the confidence investors had in stocks. Sure, they were buying government bonds, money market instruments, and mortgage bonds, basically to provide liquidity and keep those rates low. But then they said that they would also buy junk bonds, kindly referred to as ‘non-investment grade’ bonds. That means that not only would the Fed take on interest rate risk and credit risk, but they would potentially backstop default risk. If riskier companies could still borrow at less-than-loan-shark rates, they might survive this recession.
Other reasons for the rebound could be that big firms are healthy enough to survive and possibly thrive in the aftermath. At the same time, the largest five holdings make up a greater percentage of the S&P 500 than during the top of the tech bubble.
Market cap of 5 largest companies as share of S&P 500 total. COMPUSTAT, GOLDMAN SACHS GLOBAL INVESTMENT RESEARCH
Large companies have shined this year. The S&P 500 top 50 holdings are down just 4% through May 7th, while the small-company index is still down 21%.
But that can’t be the total story. Here’s where low interest rates and valuation play a role.
To start, let’s review one of the more commonly used metrics in determining valuation, known as the price-to-earnings ratio (P/E). Investors use P/E ratios as a quick way of determining where equity markets currently value a company’s stock, relative to its earnings per share. To calculate, we take the price of one share of the company’s stock divided by the company’s earnings per share.
For example, if a company’s stock price is $100 and their earnings per share for the past year is $10, their P/E ratio is 10. In other words, the company’s stock is trading at a multiple of 10 times earnings. But P/E ratios don’t tell much on their own – is 10 times earnings expensive or cheap? In this study, we compared the monthly P/E ratios of the S&P 500 over the past 50 years; but we didn’t stop there.
An often-overlooked factor when evaluating relative valuation using P/E ratios is prevailing interest rates. Why? If prevailing interest rates are at 3%, not only is the company financing its capital projects at that rate, but investors are simultaneously thirsty for greater returns that satisfy their retirement goals or pension obligations. Investors are willing to pay more during this time. The opposite should also be true. If interest rates are at 8%, not only is the company burdened with higher costs to expand, but investors have a much higher threshold of safe yield to beat with stocks.
To understand this fully, you need to see it.
The graph below plots historical P/E ratios for the S&P 500 in different rate environments from January 1970 through May 1st of this year. Each point depicts where the S&P 500’s P/E ratio was in relation to the 10-year treasury interest rate at that time.
S&P 500 P/E vs. 10-Year Treasure Rate. GLASSMAN WEALTH SERVICES
A bit messy – let’s isolate the time period from 1970 up to the global financial crisis of ’08-’09. The resulting graph is below.
S&P 500 P/E vs. 10-Year Treasury Rate 1970-2008. GLASSMAN WEALTH SERVICES
With this data, we’re able to see the plotted points follow a trend. If we draw bands on the dispersion (pictured below), we can begin to see how the lower the prevailing interest rates, the more investors are willing to pay (by measure of P/E).
S&P 500 P/E vs. 10-year Treasury Rate 1970-2008. GLASSMAN WEALTH SERVICES
But what happens when we add the time periods since the global financial crisis? Those points are in orange below.
S&P 500 P/E vs. 10-Year Treasury Rate. GLASSMAN WEALTH SERVICES
What happened to our nice dispersion? Why has the trend changed since the crisis? The answer is quantitative easing. The Fed has kept interest rates artificially low on a relative and absolute basis in an effort to maintain a financing environment to promote recovery and economic growth for individuals and businesses. But even though the trend is less defined, we can still see how points on the graph relate to each other. In the graph below, we label the points for March 1st, April 1st and May 1st of this year.
S&P 500 P/E vs. 10-Year Treasury Rate. GLASSMAN WEALTH SERVICES
The trend generated by the data points leading up to the global financial crisis could lead investors to believe lower interest rates generally justify higher P/E ratios. Adding in the points since the crisis certainly makes the trend more vague, but if the same principle generally applies, current prices could be more than reasonable and could explain why many investors are wondering how the S&P 500 could recover so quickly. Not only are interest rates low, but they are projected to stay low for the foreseeable future.
The right answer of interest rates and valuation likely falls somewhere between the old model and the current. But the point of seeing the relationship this way may partially justify the recovery we have seen.
The scattergraphs used herein were created by Glassman Wealth Services using S&P 500 P/E data and 10-Year Treasury data sourced at Multpl.com. The market cap exhibit was sourced from a Business Insider article, dated April 27, 2020.