[wp_lightbox_prettyPhoto_image link=”http://www.economicsignature.com/wp-content/uploads/2018/02/20180223-Dow-PE-ratio.png” description=”P/E ratios and yields on major indexes. ” source=”http://www.economicsignature.com/wp-content/uploads/2018/02/20180223-Dow-PE-ratio.png” title=”Hiking interest rate impacts price-earnings ratio in stock markets” ]
Our previous article (Interest rate outlook) has addressed that the interest rate will be moving up. When the rate is increasing, assets will be reevaluated. How?
Let’s begin with the relation between bond prices and interest rates. If an investor invests $100 in a bond with an interest rate of 3%, then this investment has a ratio of price (i.e., invested capital = $100) to earnings (i.e., $3 interest) to be 33.33. When the interest rate hikes from 3% to 4%, the same $100 investment will have the price-earnings ratio (denoted as P/E ratio) as $100/$4 = 25. Based on the same calculation method, the 5% interest rate will result in a P/E ratio of 20, and the 6% interest rate will lead to a P/E ratio of 16.67.
Referring to the above chart, the P/E ratios on major stock markets are about 25. When the interest rate moves above 4%, bonds enjoy a lower P/E ratio than stocks. That means, the same $100 capital would prefer switching from the stock markets to the bond markets. To maintain stocks as an attractive investment target, the stock prices have to fall or the earnings have to up. Preferably, companies will generate greater earnings so that their stock prices can remain about the same. However, if their earnings cannot catch up, stock prices will plunge.