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Interest Rates and Equity Valuations

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Personal views and opinions on understanding what money is, how existing financial rails are being reshaped, and insights on what we can learn from books and prior historical inflection points.
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Interest Rates and Equity Valuations

a look back at histroy

Kane McGukin
Aug 18, 2023
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Interest Rates and Equity Valuations

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For the chart nerds out there, Eric Yakes posted a great chart on Twitter a few weeks ago. It speaks to the different portfolio requirements in bull and bear markets.

Historical chart of CAPE and interest rates

In the chart above there is a clear relationship between historical interest rates and CAPE (Case-Shiller Cyclically Adjusted PE Ratio), or a rather inverse relationship at big turns. See the dates along the sloped black lines.

When Rates Spike

This recent spike in rates, while big, is also natural when you start at zero. Especially considering the environment these types of moves typically happen in. Starting at or near zero means that any move up is big statistically. The last time we saw this was in the 40s (same stimulus playbook being used today: Bidenomics = Roosevelt).

On the chart, you can see a similar rate spike in the late '50s, leading into 1960. The fundamentals from the '40s and into the 1950s were similar to now. Then, CAPE was expensive in relative terms, but still well below the blowoff top of 1929. That period was a much broader range of years, but similar to the CAPE structure from 2000 to now. These two periods are visually very similar in structure.

Let’s say we are in a similar environment; early and sharp rise in rates with expensive CAPE. CAPE didn’t break down until sometime in the 1970s, i.e. it stayed expensive to digest all the stimulus and dollars added to the system in the 1940s.

Stocks only got cheap after the whipsaw of the 1960s and '70s where prices went everywhere and nowhere at the same time.

The first move up 1960-66 was pretty much all of the gains for a 20-year period.

From 1966 until 1980 stocks (S&P 500) only went up a total of 20% over 14 years while CAPE collapsed into the fear of the 1980 Latam Debt Crisis. A point when it was believed equities were dead. However, this ended up kicking off the next big wave of global growth and the next major stock bull market (1980 – 2000). Many times, the contrarian view wins in financial markets. These were a few examples.

So, valuations may be stretched, but as you can see, they can remain so, as long as they (CAPE) hold their trendline. It may be a bumpy ride. If so, rebalancing will matter.

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