Do Low Interest Rates Support Current High PE Ratio?

By Henry Ma, Julex Capital Management

The US stock market has been in a bull run for almost eight years since March 2009. The stock valuation is getting higher and higher as the market continues setting records.

Currently, the 12-month trailing price-earnings ratio of S&P 500 companies is traded at 21.1, which is much higher than the historical average of 16.6 since 1970.

Many market participants are becoming more concerned about this expensive valuation, but others think the stocks are pricey for good reason.

One factor we want to consider is the impact of the current low interest rates on stock valuations. The so-called “Fed Model” simply states that the high PE could be potentially justified if the earnings yield, which is the reciprocal of the PE is significantly higher than interest rates such as of the yield of 10-year government bond.

Currently, the earnings yield (4.7%, which is equal to 1/21.1) is 2.2% higher than the ten-year Treasury rate (2.5%).  Then the question becomes: is the earnings yield attractive enough for investors to hold equities?