Is the PE10 Warped by Low Rates?


Yahoo Finance ran an article today about the PE10 and Robert Shiller who warned that the PE10 is almost as high as in previous peaks such as 1929, 2000, 2007, etc. The article raised the point made by Citigroup's Tobias Levkovich that the PE10 needs to be adjusted for today’s low interest rates and thus it is not applicable. My opinion is that when interest rates are at extreme lows then that could induce investors to overpay for things purchased with loans. Low interest rates act as a lever to make it easier to push up asset prices, thus creating bubbles. The Federal Reserve wants to raise asset prices and is using low rates to do so. Thus low rates, instead of discrediting the PE10, could help to explain why bubbles exist.

Low rates induce people to borrow more and they facilitate the borrowing by making it easier to qualify for a loan. The massive increase in debt from 180% of GP to 345% in the past 24 years is the key driver in why stock prices have been too high in much of the past 17 years.

If someone wanted to use cyclically adjusted rates to adjust the PE10 then they should consider that the Federal Reserve’s purpose in making rates low is to stimulate the economy out of the worst crash in 80 years. The crash has taken seven years to reach its previous GDP high in real terms and in population adjusted terms the economy is still at the amount of 3.5% less jobs than the 2007 peak which is a stunning gap. (If no adjustment for population then the economy has finally reached the previous peak in employment). Assuming that the bulls are correct and the recession is a simple, mild, brief recession then it is time to raise rates to normal, in which case there is no need for critics of PE10 to make special adjustments because of low interest rates. PE10 uses ten years of data. I would certainly hope in ten years or less that the economy and rates are back to normal.

If rates are going to be permanently low like in Japan then this implies a long term secular stagnation in the U.S. which implies low corporate profits and thus the PE10 is correct in warning about potential stock market problems.

If one uses the historical average real yield for the ten year Treasury at 2% versus todays real yield of roughly 1% then today’s rates don’t seem that different from eras when the yield was 14% but the real yield was 2% and inflation was 12%. During the era of high rates the real yield after taxes and inflation was sometimes negative 4%. Today a ten year Treasury yielding 2.57% might yield 1.75% after tax, producing a zero real after-tax return. Thus trying to discredit the PE10 because of low rates can backfire.

The argument that low rates ruins the PE10 is contrary to the benefit that low rates lower corporate expenses by 20% giving a 20% boost to profits. If this extra increment of profit didn’t exist then the PE10 ratio or at least the most recent few years of PE would be much higher, making the bubble metric even more alarming.

Investors need independent financial advice about the risks of using the PE10 theory to detect bubbles. I wrote an article “Why PE10 has been high for so long”.

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Don Martin, CFP®

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