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FT editor Roula Khalaf selects her favourite stories in this weekly newsletter.
The author is a financial journalist and author of ‘More: The 10,000-year rise of the global economy’.
This week saw a dramatic shift in market sentiment. Weak US economic news and some poor corporate earnings led to a sharp drop in stocks and a huge rally in the bond market that sent yields sharply lower.
This is an ironic development, given that stock market bulls have long argued that low government bond yields justify higher equity valuations. Understanding the future relationship between stocks and bonds will be vital for long-term investors.
Low bond yields were seen as good for stocks for two reasons. First, and most obviously, bulls argued that low yields meant that cash and bonds were fundamentally unattractive, pushing investors into risky assets in search of higher returns. That argument is less compelling now that both short-term rates and bond yields have risen sharply since 2021, while inflation has come down, meaning cash and bond investors can earn positive real returns.
The second bullish reason that now appears to be not so bright is a little more complex and relates to discount rates. A common approach to valuing shares is to view them as a claim on all current and future profits of the company in question. Those future profits must be discounted, as £1,000 in 10 years’ time is clearly not worth the same as £1,000 today. Bond yields are often used as the rate to discount those future profits. Lower bond yields therefore mean a lower discount rate and so tomorrow’s profits are worth more in today’s money.
Even after this week’s big 0.38 percentage point drop in the 10-year Treasury yield to 3.8%, the current yield is still higher than the 1.5% it was at the end of 2021. In other words, the discount rate on future earnings has risen. But what has happened to the S&P 500 index’s price-to-earnings ratio? It has risen, not fallen, from 24 times to 28.7 times. To be fair, there has been a small drop in the cyclically adjusted price-to-earnings ratio, which averages earnings over the past 10 years. It has fallen from 38.3 to 35.5.
But let’s put that change into context. Suppose a company’s stock is set to gain $100 in 10 years. If you use the bond yield at the end of 2021 to discount those gains, you get a present value of $86. Today’s higher yields, even after recent declines, only bring the present value up to $68. That would suggest that a fairly substantial reduction in stock valuations would be required and could explain the recent weakness.
Of course, markets may be anticipating a drop in discount rates. The Federal Reserve is widely expected to cut interest rates in September, particularly after the weak employment data July data is out today and inflation is coming down, but few people expect interest rates or bond yields to fall to the levels seen at the end of 2021.
What has been supporting markets until recently? The obvious point is that the calculation of stock valuations is twofold. While the discount rate may have risen, estimates of future earnings growth may have risen just as quickly, or even more. This is a little hard to see in the data. Average earnings per share growth for the S&P 500 this year is expected to be just 6 percent. A rebound to 11 percent is expected next year, but that’s not as impressive as it sounds: Analysts typically start the calendar year with high earnings growth forecasts, but then revise them down as the months go by.
Are markets more optimistic about economic growth? It doesn’t seem that way. The Conference Board expects annualized growth to slow to 1% in the third quarter of 2024, followed by a rebound to 2% next year. Not terrible, but not spectacular either. In any case, profit and GDP growth rates are not that closely correlated. This becomes clear when we look at the actual rate of profit growth over the past four years. According to figures from the Federal Reserve Bank of St. Louis, total corporate profits in the first quarter of 2024 were 72% higher than in the second quarter of 2020, a much larger increase than GDP. It is this run of profit growth that has so encouraged investors.
And this streak of profit growth is largely due to the success of a small number of highly successful companies. According to the Visual Capitalist website, Five tech groups (Alphabet, Amazon, Meta, Microsoft and Nvidia) averaged 57% earnings growth in 2023 and are projected to earn an average of 37% this year. These high-profile stocks have been driving the market.
Bulls point out that the Magnificent Seven companies, including Apple and Tesla, do not trade at the kind of valuation premium relative to the rest of the market that tech stocks achieved during the dot-com bubble. Moreover, the U.S. stock market is actually well below its true value. less concentrated than many other global markets.
Still, the US is far more important than other markets: at the end of June, it accounted for 72 percent of the MSCI World Index. An investor betting on global stocks is therefore heavily reliant on the earnings forecasts of a handful of companies because they maintain the rating of the majority of their portfolio. The fact that these stocks have shown recent weakness should give pause to any investor taking a long-term view.