Both interest rates and the stock market have risen handily in 2023, despite the former being a headwind to the latter. The question is how long it will be before one or the other blinks.
Although the returns on cash and bonds can’t really compare to equities longer term, it’s easy to see why higher interest rates are hurting stocks to some degree right now. When interest rates go up, they push up yields on virtually risk-free Treasuries—and even cash sitting in savings and money-market accounts—meaning that investors have less incentive to gamble on owning stocks. Certainly, owning stocks is the clear winner long term, but it’s hard to give up a risk-free return to buy into a volatile and pricey market.
That’s why higher interest rates are both a blessing and a curse, as Ned Davis Research Chief U.S. Strategist Ed Clissold writes on Wednesday, “The mantra for asset allocators has shifted from TINA (there is no alternative to equities) to TARA (there are reasonable alternatives).”
Of course, those invested in the so-called Magnificent Seven—namely
Apple
(AAPL),
Amazon.com
(AMZN), Google parent
Alphabet
(GOOGL),
parent Meta Platforms (META),
Microsoft
(MSFT),
Nvidia
(NVDA), and
Tesla
(TSLA)—need little convincing of the power of owning equities, as this cohort is nearly single-handedly responsible for 2023’s big market run.
Yet the group’s success is actually a blessing and a curse too, given its impact on valuation.
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As Apollo Global Management chief economist Torsten Sløk notes, while the price-to-earnings ratio for the
S&P 500
excluding those seven big-tech winners has hovered around 19 this year, the P/E for the Magnificent Seven has soared to 45 from 29 in 2023, making them “more and more overvalued.”
That’s even more extraordinary given the backdrop of higher interest rates, he notes, which devalue future earnings in the face of high yields today. Given that tech companies in general tend to have cash flows far out into the future, their present value should be reduced by current rates.
Thus, Slock concludes that “tech valuations are very high and inconsistent with the significant rise in long-term interest rates…In short, something has to give. Either stocks have to go down to be consistent with the current level of interest rates. Or long-term interest rates have to go down to be consistent with the current level of stock prices.”
That may be the case, but no one has told tech stocks, as the
Nasdaq Composite
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is still up this month. In other words, high multiples haven’t put off investors yet. So how to know when the party is truly close to ending?
Ned Davis’s Clissold argues that cash-adjusted P/Es might be the metric to watch.
Assigning cash a valuation of one allows investors to subtract it from a company’s market capitalization, leaving a valuation for the rest of the company. Clissold argues it’s only fair to subtract cash from earnings as well, meaning that the operating P/E formula is a firm’s market-cap minus cash and short-term investments divided by income before extraordinary items minus nonoperating income.
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Doing the math now shows that the S&P 500’s cash-adjusted P/E is 21.4, and its operating P/E is 20.2; both metrics are above historical averages of 16.2 and 18.8, respectively, but not egregiously so.
However what Clissold thinks is noteworthy is how the pattern is shifting.
During the era of near-zero interest rates, the cash-adjusted P/E was nearly always lower than the operating P/E. Companies weren’t earning much from cash, but kept plenty on hand to finance dividends and buybacks. Now however, higher rates have pushed up nonoperating income, which not only offsets higher interest rates, but also adding more to earnings.
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The upshot is that today the cash-adjusted P/E is now above the operating P/E by the largest amount since 2003, excluding recessions. “The main takeaway is that the two price/ earnings metrics are not drastically out of line with each other currently, but if interest rates prove to be the death blow to the secular bull market, the cash-adjusted P/E may present the case more clearly than traditional valuation metrics,” Clissold writes.
Put another way, in a game of chicken between rates and stocks, valuations still matter.
Write to Teresa Rivas at teresa.rivas@barrons.com