The Wall Street Waltz: 90 Visual Perspectives, Illustrated Lessons From Financial Cycles and Trends, Revised and Updated Edition

Chart 43

The Snake

The “snake” depicts one of the fundamental trade-offs for stocks and bonds over the next few years. This chart shows the average interest rate of quality corporate bonds versus the growth rate of corporate earnings as represented by the S&P 400. It's a trade-off between business's ability to get money through earnings growth versus its cost of money through borrowing. The interest-rate scale is on the left side; the earnings-growth scale is on the right. As you see, interest rates and earnings-growth rates have correlated neatly with each other. When earnings growth has been fast, usually during the latter part of rapid economic expansions, interest rates have been high. As interest rates have fallen, so has the growth rate of earnings.

This means that if historic relationships continue and interest rates keep falling, then so might the growth rate of earnings. If earnings don't grow quickly, then the stock market has a problem. Why? As of this writing, the Dow Jones Industrial Average was at about 2,100 with about $115 of underlying earnings. That translates into a P/E of 18. The P/E chart (Chart 1) says 18 is a historically high P/E.

How do you justify a high P/E? To simplify this, imagine a P/E of 20. Inverting it gives an E/P, or earnings divided by price, of 1/20th or 5 percent. You can think of that as the earnings yield of owning a business—or stock—directly comparable to the interest yield from a bond (see Chart 4). If the earnings yield is lower than ...