Occasionally, we stumble upon a graph that deserves more than the paragraph or two we typically allot in the Commentary. The chart below, courtesy of SoFi and Bloomberg is one example. It compares real rates and stock valuations.
Consequently, periods of low real rates frequently accompany higher stock valuations. Conversely, high real rates restrict economic activity. They tend to weigh on corporate profits, stock prices, and valuations. Since 1985, the relationship has been statistically meaningless when real rates are below 1.0%. Yet, despite a low r-squared for that data set, the data still trend from the top left to the bottom right, signifying that even with low or negative real yields, there is an inverse relationship.
How will the divergence end: Lower yields? More inflation? Falling stock prices? Higher earnings? Or will a combination close the irregular gap?If the relationship normalizes solely due to real rates declining, then interest rates and or inflation expectations would be lower by default. If the relationship normalizes with stock valuations falling toward the regression trend line, we must assume stock prices drop and or earnings expectations rise. Either way, the forward P/E would fall from 19.50 to 16.The risk to that math is that weaker economic growth reduces earnings forecasts, and the corresponding correction in stock prices must be larger than 18% if the relationship normalizes.The relationship between real rates and stock valuations makes a lot of sense.
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