On 12/31/20 we observed: A healthy recovery with growth and a modest uptick in inflation would be reflationary. A rapid one, inflationary. The interaction between profits, valuation, and interest rates was the primary driver in the Q1’21 stock market. This is a concept we introduced on 12/31/20.
While PE ratios are above average, historically low interest rates make such valuations reasonable, as a PE ratio is simple short hand for discounting future earnings to the present. The following chart compares the forward earnings yield (the inverse of the forward PE ratio) and the 10yr Treasury. The difference, or premium, is shown as well. On 12/31/20, the forward eps yield, at 4.4%, was below the 2000 peak, but thanks to the 0.92% 10yr, the premium of 3.5% was in line with the 20yr range. Moving forward to 3/31/21, the eps yield is actually slightly higher, at 4.5%, even though the stock market has risen. This reflects the improved economic outlook. However, the 80 basis point jump in the 10yr has pushed the premium down to 2.8%, which is the low end of the post 2008 period.
Both profits and interest rates have risen thanks to the economic recovery. Since the premium was average to start the year, the market has been able to digest the rate increase so far. But if the rate increase were to continue, it could become more of a headwind.
The example provided on 12/31/20 still explains the relationship between profit growth, interest rates, and PE well: Using the equity premium discussion above, if the 10 yr Treasury rate increased from 0.92% to 2.00%, and the equity premium was maintained at 3.5%, the earnings yield would have to rise from 4.4% to 5.5%. The equivalent on a PE basis would be to decline from 22.7 to 18.2, or multiple compression of 20%. That would be a notable valuation headwind to overcome. For example, a 20% decline in the multiple paired with a 15% rise in earnings could still result in a 5% decline in the stock market. That is far from catastrophic, but illustrates how the market has pulled in future expectations. But it also shows how a faster rise in rates could start to be an issue. For example, using the same process, a 2.5% 10 yr drops the PE to 16.7, or compression of 25%, which would easily offset a 15% earnings increase.
After this valuation analysis of the overall market, on 12/31/20, we noted: This pressure would not be even across the markets. Low rates have favored Growth over Value, as high multiples are based on future earnings. Higher rates favor current earnings and would be an advantage for Value. In addition, if it’s a “good” reflation cycle paired with an improving economy, that could further help Value style companies that are typically more economically sensitive.
The two charts to the left demonstrate how the relationship between rising rates and the Growth/Value relationship was one of the most prominent drivers of Q1’21. The top chart shows the average daily return for the S&P 500 and Value minus Growth (i.e. how much Value outperformed Growth) overall, and then broken down based on if the 10yr Treasury was up or down that day. While daily S&P 500 returns were indifferent, the Value minus Growth numbers were mirror opposites, delivering 38 bps of daily outperformance on “10yr up” days versus 34 bps of lagging on “10yr down” days.
Then, compiling these numbers for the full quarter, you can see how Value’s 8% outperformance in Q1 stems from returning 15% on “10yr up” days minus 8% on “10yr down” days. On top of reversing a long period of Value lagging Growth, this relationship has also been key for the overall market’s performance. Thanks to Value taking the baton from Growth stocks, sectors like Financials, Energy, and Industrials have kept the market rising, while 2020’s Technology outperformers have lagged. Low PE multiples and rising profit expectations is a favorable 1-2 punch. This has enabled the market to experience the reflation option in our Reflation or Inflation theme, of modest inflation offset by growing profits. The risk is that as the recovery continues to pick up steam, it shifts to an inflation scenario, where rising rates (or the Fed having to rush to pull back on QE) causes a headwind that overpowers the profit recovery tailwind.
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