So the federal reserve by cutting interest rates to zero, pulling the 10-year treasury yield down to 0.5%, 0.6%, 0.7% that really boosts the value of a dollar's worth of earnings, and it allows PE ratios to be a lot higher. Now you can get to a place where the market is overvalued. People have worried for a very long time about quantitative easing, and they've called the market a sugar high, as a result of that, I've never, for the last 10 years, I did not buy into that because if you did that model, you take earnings and then discount them with the ten-year treasury, and then compare what you find to all of history. We kept seeing a market that was actually undervalued. it, it wasn't fully pricing in that low interest rate.
It wasn't ahead of itself on earnings. And that's still true today. my view is that the market as a whole, and I'm really talking about the U.S., but I bet this is the case, around the world, is not over-valued today. How could the market be at a record high with the economy hurting this bad, but it doesn't appear to me that we are overvalued today.
Partly because interest rates are as low as they are, but even if we use a higher interest rate, the market's still undervalued because profits just didn't get hit as hard as a lot of people feared early on. In fact, if you go back to the bottom. Of the market in March, April is really when we bottomed, the U S market was predicting an 80% decline in corporate profits. That's what we determined, back using that model, but then going backwards. and figuring out what the market was expecting, and that was way over done. They're going to end up falling maybe 20%, probably a little less than that this year, so the market was way oversold, in April, and that's one of the reasons why it bounced back so hard.
The discount rate is effectively zero so that means positive earnings have much greater value than when interest rates are high. In just the same way that low interest rates allow debt loads to increase, they also allow stock prices to increase. That puts a premium on growth because potential for higher earnings in future are more attractive than steady earnings today when interest rates are low.Click HERE to subscribe to Fuller Treacy Money Back to top