Hooray! Johnny Got a D

| August 18, 2023

Not failing is a good thing. Now that earnings season is at an end, most companies beat analyst’s earnings expectations. Hannah Miao of The Wall Street Journal explains that the 79% beat rate is due to reduced expectations. Ms. Miao explains that “at the end of last year, analysts expected 2023 second-quarter earnings from S&P 500 companies to slip less than 1% from the year prior. By the beginning of the reporting season, Wall Street had changed its expectations to a roughly 7% decline. Profits were actually down about 6%.” * In other words, they thought Johnny would fail, but he got a D. Hooray!

I am concerned about this because of the current relationship between earnings growth and interest rates. How much we pay for stocks is related to prevailing interest rates. Using Robert Shiller’s cyclically adjusted price-to-earnings ratio (CAPE), the chart below shows the inverse relationship between the CAPE and long-term interest rates. There are periods where the premium we pay for stocks rises along with rates, but that is explainable by large gains in earnings. We do not have that now.

The yield on the 10-year Treasury bond peaked at 15.84% in September 1981. Rates trended lower ever since, bottoming at 0.55% in July 2020. The rate hit 4.19% this month. Yet, investors are still willing to pay large premiums for stocks that only beat pathetic expectations.

Bulls are betting on a return to a low interest-rate environment. That could happen. Artificial intelligence could lead to big gains in profits and efficiency. However, with the end of earnings season, we are entering a low-information period that could be dangerous for stocks at these levels. Caution is advised.

Online Data - Robert Shiller (yale.edu)

Market Yield on U.S. Treasury Securities at 10-Year Constant Maturity, Quoted on an Investment Basis (DGS10) | FRED | St. Louis Fed (stlouisfed.org)

* Miao, H. "Stock Rally Stalls Despite Better-Than-Expected Earnings Season." The Wall Street Journal, Online-Stocks, Aug. 13, 2023. https://www.wsj.com/articles/stock-rally-stalls-despite-better-than-expected-earnings-season-e9af704d. Accessed on 08.16.2023.