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How do interest rates affect equity valuations?

There’s been a meaningful inverse correlation between the 10-year Treasury yield and equity market multiple over time. The recent divergence isn’t likely to last indefinitely.

Interest levels affect valuations chart illustration

While not at the center of day-to-day discussions about the markets, the risk-free rate is an important concept underpinning investing decisions and market valuations. It’s the theoretical rate of return for an investment with zero risk, creating an effective starting point for market analysis and evaluating the pricing for all other investments. Short-term treasury yields are the most common proxy for the risk-free rate. As those yields fluctuate, the pricing of risk assets is expected to adjust as well to varying degrees.

Short-term treasury yields don’t tell the full story though. Historically, there’s been a strong inverse relationship between longer-term yields and equity market valuations. As shown in the chart above, a rising 10-year Treasury yield has tended to correspond with lower P/E multiple for the S&P 500. The reverse has also been true, as illustrated most recently in 2020 as the yield on the 10-year Treasury fell well below 1% and the P/E multiple on the S&P 500 surged.

The opposite has also been true since the start of 2022, as short-term rates have risen by about 3.5%, which is a considerable move in a relatively brief period. In fact, yields are at levels not seen in nearly two decades, as noted in our associated piece. Recently, there has been a disconnect in the relationship between the risk-free rate and P/E multiples, a divergence that’s likely to dissipate over time. Whether that comes via a reversal in interest rates, a reduction in stock market multiples, or a combination thereof remains to be seen.

Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.

Data sources for peer group comparisons, returns, and standard statistical data are provided by the sources referenced and are based on data obtained from recognized statistical services or other sources believed to be reliable. However, some or all of the information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis nonfactual in nature constitutes only current opinions, which are subject to change. Benchmarks or indices are included for information purposes only to reflect the current market environment; no index is a directly tradable investment. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree.

Plante Moran Financial Advisors (PMFA) publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the companies or sectors mentioned herein may not be appropriate for you. You should consult a representative from PMFA for investment advice regarding your own situation.

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