Have the drivers of equity price appreciation run out of steam?
Given the current uncertainties facing financial markets it is worth taking a longer-term view of the relationship between equity prices, bond yields and earnings. Looking back over the history of equity and bond markets since the late 1980s we observe a secular decline in Treasury yields and corresponding rise in equity prices – which reflects expanding P/E multiples (i.e., share price relative to earnings), due in large part to the drop in yields, as well as rising earnings. More recently, however, bond yields appear to be bottoming while earnings have flattened – neutralizing the two main drivers of equity price appreciation over the last three decades.
The current environment of slow but steady economic growth and inflation suggest an end to the secular decline in bond yields once 10-year Treasuries top 2.5% - with a likely levelling off in a range between 3% and 4%. The wild card is future earnings growth given the new administration’s markedly different approach to taxes, regulation, industrial and trade policy implying a higher risk premium for equities. This suggests that current P/Es are too high on both counts and stocks overpriced.
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