One Cheer for Low Rates

Companies haven’t been doing so hot this year, but investors are too busy cheering on low rates to be all that worried.

The problem is that the conventional wisdom is mostly flawed: Falling rates aren’t much of a reason to buy stocks.

Companies are in the midst of reporting results, and in aggregate it is difficult to qualify them as anything more than a disappointment. Current estimates suggest S&P 500 earnings slipped 2.2% in the second quarter from a year earlier, according to FactSet. For all of 2019, analysts are now looking for S&P 500 earnings growth of just 1.7%, down from the 6.6% they expected at the outset of the year.

Yet stocks are dancing near record highs, with valuations getting increasingly steep. The S&P now trades at 16.9 times expected earnings—near its highest level since March 2018, when the profits boost from corporate tax cuts had yet to be fully reflected in analyst estimates.

The Federal Reserve building in Washington.


Photo:

chris wattie/Reuters

The simplest answer for why investors are assigning high valuations to stocks even as earnings slow is interest rates. With heightened worries about a slower global economy, and with the Federal Reserve shifting from tightening to easing policy, the 10-year Treasury now yields just 1.9%, compared with nearly 2.7% at the start of the year. With Treasurys offering such scant returns, stocks are all the more attractive.

Or so the thinking goes. The sticking point is that Treasury yields are largely a reflection of bond investors’ long-term growth and inflation forecasts. The lower those forecasts go, the lower yields go. But lower growth and inflation also translate into lower nominal earnings growth over the long term. Paying more for less—accepting a higher P/E for less earnings growth—seems foolish. This was the basic problem with the so-called Fed model, a valuation tool based on the relationship between stocks’ price-to-earnings ratios and the yield on the 10-year Treasury note that was popular in the late 1990s bubble era.

Share Your Thoughts

Do you believe that low interest rates make stocks more valuable, all else being equal? Join the conversation below.

Of course the Treasury market could have it wrong. Maybe the Fed’s decision to cut rates on Wednesday and other central banks’ easy stances will rekindle global growth and inflation, leading to much stronger earnings in the years ahead. In that case, long-term interest rates should soon be headed higher. By that twisted logic, a much improved outlook would count as a reason to sell stocks.

At a press conference following the Federal Reserve’s rate-cut announcement, Fed Chairman Jerome Powell explained that there was an “insurance aspect” to the decision. Photo: Reuters

Write to Justin Lahart at justin.lahart@wsj.com

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