One such model was proposed in a 2017 article in the Journal of Portfolio Management by Research Affiliates founder Robert Arnott and several colleagues. They found that P/E ratios tend to be lower when real interest rates, or those adjusted to remove the effects of inflation, are either too high or too low. The “sweet spot,” as far as P/E ratios are concerned, is when real rates are between 3% and 4%. Since real rates currently are below 1%, Mr. Arnott’s research provides no support for the above-average current P/E ratio.
In an email, Mr. Arnott poses a rhetorical question for those who believe that today’s low interest rates should automatically translate into higher P/E ratios. If that were the case, “then why don’t negative real interest rates in Europe and Japan justify even higher valuation levels [than in the U.S.]?! Instead, these markets are priced 20-40% cheaper than the U.S.” as judged by their P/E and CAPE ratios, he writes.
Taking historical comparisons as a basis for a world with trillions in negative yielding bonds does not make sense. Once interest rates go below zero it sets of a stampede for yield among yield-to-worst investors and creates a momentum driven trade in the opposite direction for traders. The big difference between Europe and Japan compared to the USA is urgency.Click HERE to subscribe to Fuller Treacy Money Back to top