AFMC - Stocks Haven't Been This Expensive In More Than A Decade

Summary

• Rates are rising, and the dollar is straightening, tightening financial conditions.
• On top of tighter financial conditions, stocks haven't been this overvalued in 15 years.
• Higher rates should lead to lower PE ratio and lower stock prices.

Rates are rising, the dollar is strengthening, and the vice of tightening financial conditions squeeze stocks lower. On top of that, earnings in 2023 are estimated to be flat vs. 2022, which leaves stocks expensive compared to growth and bonds.

Stocks haven't been this expensive to bonds in 15 years. The Nasdaq 100 2023 earnings yield (the inverse of the PE ratio) less the 10-year real yield makes the NDX the most expensive relative to real rates in at least 15 years. That's because the Nasdaq 100 has risen dramatically off the 2022 lows, while the 10-Year real yield has not fallen by a similar amount.

Not This Expensive In More Than A Decade

The 2023 Nasdaq PE ratio is 23.9, which means the Nasdaq 100 earnings yield is 4.2%, and with the 10-Year real yield now at 1.5%, the spread between the two is 2.7%, that is the lowest equity risk premium between the NASDAQ earnings yield and the 10-year real yield since at least 2010.

There's also this relationship between the S&P 500 earnings yield and the 10-year nominal rate. The earnings yield for the S&P 500 in 2023 is 5.99%, while the 10-year rate is currently trading around 3.9%. That means the spread between the two is currently 2.1%. That makes the spread between the S&P 500 earnings yield and the 10-year nominal rate since 2007.

This spread had narrowed mostly because financial conditions had eased. The same relationship had been seen in high-yield credit spreads, which have also contracted, as noted by the CDX high-yield spread, which has also fallen in recent weeks. But now, as rates rise and the dollar strengthens, financial conditions should tighten, and that means spreads should begin to widen again, which should cause the equity risk premiums to widen again. That means the PE ratios of the Nasdaq and the S&P 500 should start to contract.

Rates Breaking Out

On top of this, rates are breaking out, and the higher rates rise, the more expensive stocks shall become. The 10-year rate is now breaking above resistance at 3.90%, and a close above that yield will confirm a double bottom in the 10-year. This would lead to a projected move higher in the 10-year back to its prior highs of around 4.3%.

We're also seeing the 10-year real yield break higher, and it could rise back to its prior highs of around 1.75%.

Higher Rates Mean Lower PEs

A move in higher rates means that the earnings yields of the Nasdaq and the S&P 500 should rise by around 25 to 50 bps to see their valuation stay relative to changes in bond yields. This would suggest that the Nasdaq earnings yield rises to between 4.5% to 4.75%, while the S&P 500 rises to around 6.25% to 6.50%. That change in earnings yield would equate to an S&P 500 PE ratio of 15.4 to 16 and 21 to 22 for the PE of the Nasdaq.

Those PE ratios would value the S&P 500 at roughly 3,550 and 11,055 for the NASDAQ 100. This assumes earnings of $502.50 for the Nasdaq 100 and $221.08 for the S&P 500 in 2023.

At this point, the equity markets are being squeezed lower by the pressures of tightening financial conditions and earnings growth deterioration, which makes the indexes expensive when considering where the risk-free rate is and from the perspective of no earnings growth this year.

The higher rates climb and the more the dollar rebound, the more pressure there will be on equities to adjust lower as financial conditions tighten and the cost of capital becomes more expensive.

The fact that stocks are now the most expensive in 15 years, as rates rise and financial conditions tighten, makes it a challenging environment to be bullish, and the likelihood of the next leg lower strengthening.

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