Goldman Sachs chief U.S. equity strategist David Kostin warned investors this week that further increases in U.S. inflation-adjusted yields would have extremely negative effects on equity markets, potentially driving the S&P 500 16 per cent lower from current levels.
In essence, the TINA phenomenon – there is no alternative to equities with bond yields so low – that has helped drive stocks higher across the globe is at risk.
And Thursday’s market response to higher-than-expected U.S. inflation data – a rise in real yields and an immediate sell-off in U.S. stock futures – has only served to underscore the importance of inflation-adjusted yields to equity valuation.
The comparison between inflation-adjusted (or real) bond yields and equity valuations is the chart I’ve followed most closely over the past two years. The connection is clear – valuations, and by extension stock prices, have climbed as yields fell.
This made perfect sense. As real yields dropped deeply into negative territory, indicating that bond holders would lose money annually once inflation was taken into account, more investors shifted assets from fixed income to equity.
The accompanying chart shows how this worked, and how the formerly bullish trend is now in reverse. The blue line is the Nasdaq 100 forward price-to-earnings ratio and the purple line is the real yield as represented by 10-year Treasury Inflation Protected Securities, or TIPS. (Note that the TIPS yield is plotted inversely to better show the trend.)
Inflation-adjusted yields vs. equity valuation:
’TINA’ no more?
Nasdaq 100 fwd. P/E ratio
10-yr. TIPS yield (inverted)
40
-2.5%
-2.0
35
-1.5
-1.0
30
-0.5
25
0.0
0.5
20
1.0
15
1.5
2017
2018
2019
2020
2021
‘22
the globe and mail, Source: bloomberg;
scott barlow
Inflation-adjusted yields vs. equity valuation:
’TINA’ no more?
Nasdaq 100 fwd. P/E ratio
10-yr. TIPS yield (inverted)
40
-2.5%
-2.0
35
-1.5
-1.0
30
-0.5
25
0.0
0.5
20
1.0
15
1.5
2017
2018
2019
2020
2021
‘22
the globe and mail, Source: bloomberg;
scott barlow
Inflation-adjusted yields vs. equity valuation: ’TINA’ no more?
10-year TIPS yield (inverted)
Nasdaq 100 forward P/E ratio
40
-2.5%
-2.0
35
-1.5
-1.0
30
-0.5
25
0.0
0.5
20
1.0
15
1.5
2017
2018
2019
2020
2021
‘22
the globe and mail, Source: bloomberg; scott barlow
I chose the Nasdaq over the S&P 500 for two reasons. One, the correlation between TIPS yields and the Nasdaq is significantly higher than the connection between yields and the S&P 500. The second reason extends from the first. The fact that the correlation is higher with the Nasdaq supports the theory that the pandemic-era rally was driven by technology stocks that were viewed as largely immune from COVID-19-related economic and profit growth slowdowns. (The Nasdaq 100 index comprises the 100 largest non-financial companies listed on the Nasdaq Stock Market.)
It’s difficult to overstate the dominance of technology and technology-adjacent stocks in the Nasdaq. The top 10 stocks in the index are, by market capitalization, Apple Inc., Microsoft Corp., Alphabet Inc. Tesla Inc., Nvidia Corp., Meta Platforms Inc., Broadcom Inc., Adobe Inc., Cisco Systems Inc. and PayPal Holdings Inc. Combined they make up 65 per cent of the Nasdaq 100′s total market capitalization.
Correlation calculations verify the close relationship between the two data series visible in the chart. This math doesn’t change no matter how I show the data series on the chart, but there is some leeway as to how the scales on the Y-axis are chosen to illustrate the connection between them.
After building the chart as fairly as I could, it appears now that the Nasdaq is reflecting real yields slightly higher than current levels (the blue P/E ratio line has fallen more than the other line implies it should). This implies that equity investors are pricing in higher inflation-adjusted yields.
Mr. Kostin’s 16-per-cent market correction for the S&P 500 was based on the possibility of real yields climbing to 0.4 per cent from the current minus 0.47 per cent. To assess how this could change we look at the right-side Y-axis on the chart, which shows the TIPS yield. The purple line would drop to 0.4 per cent and we assume that the recent pattern holds and the blue P/E ratio line moves roughly in tandem. The P/E line moving to 0.4 per cent on the right-hand axis corresponds to roughly 22 times on the left-side Y-axis (the correct scale for P/E ratio).
The current P/E ratio for the Nasdaq is 26 times forward earnings based on expected total profits of US$568 (26 times US$568 is about 14,770 – the Nasdaq 100 index’s opening level on Wednesday). At 22 times earnings, and profits unchanged, this leaves the Nasdaq 100 near 12,500, or about 15 per cent lower than current levels.
Again, these are rough estimates based on the chart as constructed. The goal here is to describe how important real rates have been in driving equities higher, and why equities will become less attractive if rates continue to climb.
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Scott Barlow