What if stocks haven’t gone up enough in the first place?

Brian Wesbury’s latest commentary for First Trust looks at the recent yield curve / higher rates hysteria and makes the comment that we might be in more danger from a rising 10-year yield if in fact stocks had become overvalued in advance. But through one metric – capitalized profits – stocks haven’t gotten expensive enough for rising rates to be a problem just yet.

Emphasis mine:

And our models show that low interest rates were never priced into equity values, either. We measure the fair value of equities by using a capitalized profits model. Simply put, we divide economy-wide corporate profits by the 10-year Treasury yield and compare these “capitalized profits” to stock prices over time. In other words, we compare profits, interest rates, and equity values and determine fair value given historical relationships. The lower the 10-year yield, the higher the model pushes the fair value of stocks.

Because the Fed held short-term rates so low, and gave forward guidance that they would stay low, they pulled longterm rates down, too. As a result, over the past nine years, artificially low 10-year yields have caused our model to show that stocks were, on average, 55% undervalued. In other words, stocks never priced in artificially low interest rates. If they had, stock prices would have been significantly higher, and in danger of falling when interest rates went up.

Josh here – of course, bears would point out that earnings per share would not have gotten to these levels absent the shrinking floats engendered by these low rates, but that’s another fight for another day.

Source:

3% – Why it doesn’t matter 
First Trust – April 30th, 2018