Milan Cacic
October 21, 2022
Money Education Social media Economy Professionals Commentary In the news News Weekly update Weekly commentaryIT IS STILL ALL ABOUT THE FED!
The price that stocks trade at, relative to what they earn is called the price-to-earnings ratio. This ratio is directly correlated with long-term interest rates. When interest rates are high the price-to-earnings ratio is low. When interest rates are low the price-to-earnings ratio goes up. When you think about this logically it makes sense. For example, if you can earn 10% on a Government of Canada bond, why would you own a company that trades at 10 times its earnings, which is theoretically equivalent to a 10% yield. These ratios can get very high and skewed when interest rates get very low or go to zero like we just had.
Currently, the market is trying to figure out what ratio these companies should be trading at. In the last 6 months, interest rates have gone from 0.5% to over 4%. This has a significant effect on the P/E ratio that these companies trade at. Companies in North America are now trading at historically cheap ratios. This is especially true for Canadian companies. The chart below illustrates just how cheap large cap Canadian companies are compared to their American counterparts.
If interest rates continue to go higher, then it is possible that these ratios will go lower. However, if the Federal reserve starts to slow down the rate increases, then we could see some relief in the market and also maybe some P/E multiple expansion. Without getting too much into the math in these models, if the US 10-year treasury yield drops from 4% to 3%, this would add 5 multiples to the price to earnings ratio. This means that if a company has a 15 times P/E ratio then it would go up 33% so it was trading at a 20 times P/E ratio. I am not suggesting that the 10-year US treasury is going to fall from 4% to 3% but rather, I do want to show you just how sensitive stock multiplies are to interest rates.
I have also included a piece from CIBC Asset Management by Michael Sager entitled “Are We There Yet?”.
As always if you have any questions please feel free to give us a call at any time.
Have a great weekend.
Milan