Why Low P/E Comes With High Interest Rates

By Hui Zhong

If we look back the history of the stock market and bond market, we may find a very interesting correlation between the P/E and bond yields.  That is when the stock market bottoms the bond yield also peaks.  In the two depressions in the past 100 years, when the market finally rushes to the bottom the yields typically are beyond 6%, so is the dividend rate.

Lower stock price is always associated with a lower P/E value during a depression.  The stock market, as indicated by my real-time GDP thermometer model, reflects the aggregate sales of the whole nation, or the total sales of the underlying companies.  When sale drops the stock price dips even though the earnings do not get hurt.  Actually, according to my theory, the stock market has nothing to do with earnings and is determined uniquely by the sales.  With the same profit margin, high sale always brings about higher earnings, so the higher stock price.  But in a depression, when money becomes more and more expensive or the interest rates become higher and higher, a business needs to bring higher efficiency to generate profits because it has to outperform the bond market to keep on being attractive by the investors.  That is lower P/E, or lower ratio of sale to profit, or higher profit margin.  When bond market pays something around 6% yield, the business has to pay higher than 6% return to its investors, or a higher than 6% profit margin.  Here are the market behaviors when a depression bottoms.  It is no wonder why they are all correlated.

  • Stock market bottoms
  • Bond yields peaks
  • Profit margin peaks
  • P/E bottoms
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