Figure 1 shows the historical relationship between earning yields of S&P 500 Index and ten-year Treasury yield. There is a strong positive relationship between earnings yield and interest rate. When the earnings yield is regressed against ten-year Treasury yield with monthly data since 1970, the equation is estimated as:

Earnings Yield (y) = 0.5419*Ten-year Treasury Yield (x) + 3.2387.

Data Source: Bloomberg

So, based on the Fed model estimates in the equation above, the earnings yield at current interest rate environment should be 4.6%, which is roughly the level where the market is traded now.  Figure 2 compares the historical earnings yield with the estimated earnings yield with the Fed model. After eight years of bull market, the US equities are not cheap even after taking into consideration the current low interest rates.


Data Source: Bloomberg

Given the current high PE multiple, it will be hard for the stock market to continue moving higher through PE expansion in the environment of rising interest rates. Thus, earnings growth becomes critically important in determining the future market direction. Trump’s campaign promises on economic policies such as trillion-dollar infrastructure spending, tax cuts and de-regulation can help the economic and earnings growth. However, whether those policies will materialize remains to be seen.

Henry Ma is the President & CIO at Julex Capital Management, a participant in the ETF Strategist Channel.