The 10 Year Treasury Yield & The Stock Market

There is a very important historic coupling between the return on equities and the yield on the 10 year Treasuries . I have examined this relationship going back to 1920, using a surrogate money yield rate ( AAA corporate Bonds) for the data before 1953 and have discovered that the inverse of the rate can give you a fairly good indicator on what the stock market can "Max Out" at in terms of Price Earnings ratio. 

Lets use the current numbers to illustrate my point. Currently, the 10 year Treasury Yield is about 4%. Divide 100 by the yield of 4% and you come up with 25. 25 would be the proposed "Max Out" of the Price Earnings ratio of the SP 500. If the current PE of the SP 500  is above the Max Out rate, then the market is battling against fair market valuation .. If the SP 500  PE is well  below the Max Out rate, then the market is favorable for a a rise. 

Lets see how this has played out over time. In late 1970s and the early 1980s, the 10 Year Treasury yield was over 10%. This would imply a max out for the SP 500 Price earnings ratio of 10. And sure enough, we find that in the late 1970s and early 1980s, the PE ratio of the SP 500 was in the high single digits.  

In the secular Bull Market during the period of 1950 to 1966, the average 10 year treasury yield was 3%, a Max Out rate of 33. The Price earnings ratio for the market ranged from 7 to 15 in that era, well below the Max Out rate, and consequently stocks had a terrific 16 year run. 

Where do we stand now? Current PE for the SP 500 is 33.71, well above our current Max Out rate of 25. Even if the Fed were to drop interest rates another 1/2 a percent (which they indeed did do on Wednesday) , we would still be exceeding the Max Out rate by three points.  Compare this to the beginning of the great bull run of 1995 to 2000, when the max out rate was 17 and the SP500 PE was only 13. To achieve a similar ratio today, the market would have to be trading at a PE of 19 which would mean a stock market price  level nearly 43 percent less than current levels!

What can readers of the Lussenheide Investment Warrior Report conclude from this study?...

1) The next 10 to 20 years will be a secular Bear market with broad based up and down moves revolving around the zero line. The earnings of stocks need much time to catch up to current valuations.  Timing as is practiced here  will be the only way to make decent returns in the market. Buy and Holders will be battling against the tide. 

2) All investments are in competition against each other. They battle against the risk free return of money markets and treasury yields. The market eventually  demands compromises and valuations of stocks to compete with the risk free yield of Money Markets and Treasuries. This reasoning can also be applied to the value of bonds, real estate and other assets. In fact, the income  yields of Real Estate Investment Trusts have historically tracked the 10 year treasuries very closely. 


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