Shiller P/E levels compared with the 10 Yr. yield by decade:
Starting with 1870-1900, we can see that interest rates were falling, and stock valuations were rising.
Interest rates were on the rise, stock valuations were in decline. Remember that the Federal Reserve was founded in 1913, and it was just starting to come in to its own and exert control over interest rates. Some people, like Milton Friedman and his followers, blame the Depression of 1920 (the “Forgotten Depression”) on the Fed hiking interest rates in 1920 from already elevated levels. But there were of course other factors, like the end of WWI and the Spanish Flu pandemic of 1918-19.
Again the inverse relationship is clear. Soon it will get not so clear.
But before we go any further, why did stocks go up so much in the 1920s? It’s not like interest rates fell that much. I think there was a lot that contributed to it: for one, the 1920s was a decade of real, genuine innovation and technological advancement. Radios, cars, refrigerators, aviation and so many other modern amenities and industries we take for granted today were all distributed to the masses starting in the Roaring ’20s. Really the 1920s was the true dawn of the modern age. It was a decade of remarkable technological and industrial innovation.
Plus, you had the “return to normalcy” aspect of it: World War I was over and America was in much better shape than war-ravaged Europe, comparatively (because the war was fought over there, not over here). The Flu pandemic was in the rearview. Plus the Republican presidents throughout the decade were staunchly pro-capitalist and laissez-faire, perhaps to a fault, and this enabled the economy to go bananas.
So let’s not just say that the Roaring ’20s was purely a function of declining interest rates. There’s obviously way more to it than interest rates. What I’m trying to establish here is that in the most general sense, low interest rates = rising stock valuations, and high interest rates = falling stock valuations. Obviously the extent to which stocks rise and fall during these periods is different, and influenced to a large degree by politics, geopolitics (i.e. war and peace) and technological innovation. But in the most watered-down, rudimentary sense: there’s an inverse relationship between stock valuations and bond yields.
Around 1933, interest rates started falling and the market began rallying from the depths of the Great Depression. Stocks increased until about 1937, but the economy was hit by a sharp recession that year even as interest rates were still falling, taking the stock market down considerably. Rates, however, kept falling throughout the 1930s and into the early 1940s. Around 1942, the market started rallying again even as interest rates were rising. It’s as if the inverse correlation between stocks and interest rates became a positive correlation around 1950.
Rates were going up the whole time, and stocks were also going up. However, late in the 1960s, rates spiked significantly and the market tanked. We also saw this happen in the late 1950s: the 10 yr. yield spiked and the market corrected.
It seems as if during this 20-year span, the market was not only fine with the rising interest rates, it liked them. But it didn’t like when rates rose too quickly.
Maybe this is because rising interest rates were a sign of rising inflation (i.e. a response to it), which may have been seen as a good thing during this period because there was significant deflation during the Great Depression. Even by the 1970s, the Great Depression was not all that far in the past; maybe investors associated deflation with the Great Depression and cheered inflation because it was the opposite of what happened in the Depression. That’s just my theory, though.
Another theory is that, as you can see if you look closely at the chart, you can see that rising rates were good for stocks, but not when rates rose too sharply. Economic growth is obviously a good thing, but the market is like Goldilocks: the economy can’t run too hot or too cold, it has to be just right. If it runs too hot, then inflation can get out of control and rates will spike, and that can cause a recession.
So steadily rising rates can be good for stocks, while sharply rising rates are bad.
Now comes the era of stagflation: rising inflation and rising unemployment. Interest rates rose dramatically to all-time highs, and stock valuations fell considerably. The biggest stock crash was the bear market of 1973-74, which as you can see coincided with a sharp rise in interest rates after a sharp drop.
Here we can see that interest rates peaked around 1982, and at the same time, stock valuations bottomed out. Once Paul Volcker–the Fed Chairman at the time who decided that the only way to get inflation under control was to jack interest rates up to unheard-of levels–decided that inflation was sufficiently tamed, interest rates started dropping rapidly, and the stock market took off on an epic run. Rates have been in decline ever since 1982, and bonds remain in a nearly 40-year bull market to this day, although bonds have been getting killed in recent months.
Here the relationship is also clear: interest rates down, stocks up.
We see a spike in interest rates in the late 1990s, and it probably was what caused the tech bubble to burst. The Fed began cutting rates in response to cratering stock prices, and stocks finally found a bottom in early 2003. Stocks turned around and went up from 2003-2007, but the Fed began a hiking cycle in 2005 that eventually burst the housing bubble and led to the Great Recession, leading to a further collapse in stock valuations.
If you look at the chart, it might at first glance look like we had falling interest rates and falling P/Es, and that’s technically true if you go just by where both measures were in 2000 and where they were by 2010. But if you look on the 10 Yr. side, you can see there was a period of rising rates, and that’s that hiking cycle in the mid-2000s that eventually led to the crash of ’08.
After the crash of ’08, stocks began rallying and have been in a long bull market ever since. Bond yields have been coming down ever since about 2007.
And here’s the overall chart:
Look at the long term chart of interest rates, we can see that even after the recent spike in rates, interest rates are still at all-time lows. In fact, interest rates today are apparently at 5,000 year lows, at least according to Bank of America:
Now obviously there’s some serious gaps in the chart the further back you go, but it’s awesome that the B of A analyst went back to see what interest rates were back in like the days of the Pharaohs, and Ancient Rome.
Rates seem to average between 3-6% historically, and we’re well below that range today. The only period that even comes close to the current rate low-rate environment is the 1930s, and we saw interest rates pick up in a major way, albeit not until the mid-1950s.
Eventually rates will go back up to a normal range. The million-dollar question is, when?
A lot of people think it’ll happen soon due to the inflation expected to come from re-opening. This remains to be seen, but I think it’s safe to say that whenever economic activity picks back up to a substantial level, inflation will rise and interest rates will have to rise in response.
The Fed was already hiking rates starting around 2016, getting the EFFR (effective federal funds rate) up to 2.5% in 2018 before cutting rates in 2019. Then of course rates went straight to zero during Covid:
The Fed still maintains it won’t hike rates until 2023.
But if inflation starts running too hot, they may have to revisit that position. The most important question is not what level of inflation we’ll see, but what level of inflation the Fed will tolerate.