"I am wiser than this man, for neither of us appears to know anything great and good; but he fancies he knows something, although he knows nothing; whereas I, as I do not know anything, so I do not fancy I do. In this trifling particular, then, I appear to be wiser than he, because I do not fancy I know what I do not know."

Socrates, 5th Century BCPhilosopher

This quarter we’re going to take a break from our usual practice of surveying the investment landscape and instead focus on a single topic which begins on the next page.

We have attempted to write in a manner interesting to students of the markets but still understandable by the layman. Most of the technical details behind our exercise will appear in footnotes at the end of this letter... we suggest casual readers skip these.

“How much should stocks go up when rates go down?”
or
“How I learned to stop worrying about valuation and love stocks.”

It is relatively common knowledge that when interest rates decline stocks ought to rise, and they typically do. We are far from the first investors to ponder the effect of interest rates on valuation, but the majority of the analyses we have seen have been empirical, i.e. more about what happened in the past. A good example is the following graph which compares 10-year treasury rates (bottom axis) with the earnings yield of the S&P 500 (inverse of the P/E) on the side axis. The image contains a linear “best fit” line, but it would be quite a jump to say that the market “ought” to price itself to be on the line.

Given that the market rise of the past few years was probably somewhat justified by the decline in interest rates, we set out to try and demonstrate to ourselves just how much stocks should move when interest rates fall. The analysis is simple enough, but we hadn’t seen anyone else do it and wanted to see for ourselves. From here it is an irresistible step to ask “is the stock market expensive?” In preview, we answer with a rather qualified “no”.