Interest Rates

suggest that the US stock market is

Overvalued

Overview

US interest rates are currently near all-time lows. Broadly speaking, this means that investments made in low risk products (e.g., bonds) are paying little in returns, and so are not highly demanded by investors. Traditionally risk-averse investors have little else to do with cash right now other than to put it into riskier equities, which drives the stock market higher. This model looks at the relative performance of the US stock market given current interest rates. As of October 22, 2021, we observe that relative to a normal interest rate environment the US stock market is Overvalued.

Below is our composite chart showing the position of the S&P500 relative to its average position, and adjusted for average interest rates. Read the detail below to understand the inputs and limitations of this model.

Overview
S&P500 relative to 10Y Interest Rates
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Theory & Data

There are two core reasons that stock markets and interest rates tend to move inversely with one another.

  • Lower Corporate Profits. As market interest rates rise, that means that firms who wish to borrow money in order to fund profitable projects will need to pay more in interest payments. This will necessarily lower profits. In some cases, it means the firms will not be able to do the project at all. Lower profits mean lower stock prices, since stock prices are fundamentally a measure of all future profits of a firm. The opposite is true as well - as rates fall firms are able to borrow more, which increases profits and expands economic output.
  • Less Demand for Equity. As market interest rates rise investors are able to earn higher yields by investing in debt instruments (bonds, etc) rather than equities (stocks). This lowers the demand for stocks, which lowers their prices. Likewise, when interest rates are very low, investors seeking a return on their cash don't have many available choices, and tend to get pushed into riskier assets (lower quality bonds, stocks), in order to make a return. This drives those prices higher.

There is plenty more to know about the inverse correlation between stocks and bonds. Check out these resources for more info.

Suffice it to say here that what we are primarily concerned with is the question: Is the current market fairly valued when considering current interest rates?

Current Values & Analysis

Interest Rates

Figure 1 below shows the Ten Year Treasury Bond rate over the last ~60 years, from 1962 to present day. Rates spiked in the '70s and '80s as a response to high inflation at the time, and since then have been on a pretty steady downward trajectory.

Figure 1
Figure 1. Ten Year Treasury Bond Interest Rates
Trendlines

The average (arithmetic mean) of this rate over the entire timeframe is roughly 6%. Rates haven't been in that neighborhood for about 20 years, but history does suggest that a healthy economy should revert back up to higher rates eventually. ("Eventually" here is quite a loaded term, and speculating on future Fed monetary policy decisions, or on fundamental changes to Fed policy and philosophy, are outside of the scope of this article, but only a Google search away).

Figure 2A below shows the same chart as above, only this time with the 6% average trendline drawn in. Figure 2B in blue shows the real S&P500 over the same time frame, as well is its corresponding trendline. [This comes directly from our S&P500 Model detail, so look there for more detail on the data and trendline.]

Figure 2A
Figure 2A. Ten Year Treasury Rate with Trendline
Figure 2B
Figure 2B. S&P500 with Trendline
Detrending the Data

Instead of looking at the raw values for each of these charts, we can instead think about each of them in terms of their performance relative to their respective trendlines. Are they above or below the respective trend? In the two charts below we map each chart in terms of the number of standard deviations above/below the value of its respective trendline.

You can see in the left chart that the most current 10Year interest rate is about ~1.75 standard deviations below normal. Likewise, you can see in the chart to the right that the S&P500 is currently ~1.6 standard deviations above its trendline. As explained above, it is not surprising that this is the case. We should generally expect that when interest rates are relatively high, stocks should be relatively low, and vice versa.

Figure 3A
Figure 3A. Ten Year Treasury Rate - # of Standard Deviations from Trendline
Figure 3B
Figure 3B. S&P500 - # of Standard Deviations from Trendline
Comparison

As mentioned above, we should generally expect that when interest rates are relatively high, stocks should be relatively low. What ought to be very interesting to us is when interest rates and stock prices are in the same phase (both high or both low, relative to their trendlines). Since we are already expressing data in both charts in terms of standard deviations above/below trend, we can just sum the two charts together to see where they are out of phase.

Figure 4
Figure 4. Composite Sum - S&P500 vs 10Y Rates, Std Devs from Trendline
Summary

Figure 4 above shows our final chart. The two relative performance indicators for interest rates (red) and stocks (blue) have been combined, showing a composite value in purple. When greater than zero, this indicates that rates are high, and stocks are also high. The peak here is during the 2000 internet bubble. During this time stocks prices were very high, but bond prices were right around average... meaning that even though investors had other good options to invest in, and despite the high interest rates firms needed to pay in order to borrow money, stocks were still very high. That's a clear bubble - which we all know in retrospect popped loudly and abruptly.

On those merits, we are not in a similar bubble today. As of October 22, 2021, the 10Y Treasury bond rate was 1.68%, which is 1.4 standard deviations below normal. Likewise, the S&P500 value of $4,545 is 2.5 standard deviations above its own respective trendline. Summed together, this gives a composite value of 1.1 standard deviations above normal, indicating that stocks are currently Overvalued.

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Data Sources

The below table cites all data and sources used in constructing the charts, or otherwise referred to, on this page.

Item Source
10 Year Treasury Bond Rate Board of Governors of the Federal Reserve System (US), 10-Year Treasury Constant Maturity Rate [DGS10], retrieved from FRED, Federal Reserve Bank of St. Louis;
SP500 Price Yahoo! Finance S&P500 Daily Close Values
CPI U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: All Items [CPIAUCNS], retrieved from FRED, Federal Reserve Bank of St. Louis;