In a world where the real interest rate is 2%, is a P/E ratio of 19 reasonable? This is the "high dividend dilemma" in the US stock market.

With the United States entering a high-interest rate era, the overvalued U.S. stock market may face risks in the future.

According to a report from Bloomberg on Monday, the futures market indicates that the market's expectation of higher interest rates for a longer period of time is increasing. As yields remain high, the attractiveness of high-risk investments such as U.S. stocks is diminishing.

Based on calculations from 10-year U.S. Treasury inflation-protected securities, the real yield in the United States recently reached 2%, the highest level since 2009. In response to this, Lisa Shalett, Chief Investment Officer of Morgan Stanley Wealth Management, stated that valuations must adapt to changes in interest rates and real interest rates. As the cost of capital rises, valuation multiples will also decline.

According to data from FactSet, the expected earnings multiple for the U.S. stock market index in the next 12 months is 18.6 times, higher than the 16.6 times at the beginning of the year and the average multiple of 15.8 times over the past 20 years.

However, with a real yield as high as 2%, is a price-to-earnings ratio of 19 still reasonable?

The Era of High Interest Rates is Coming

Former New York Fed President Bill Dudley pointed out in a Bloomberg column that

The pattern has changed, high yields are back, and the bond bull market that began in the early 1980s has ended.

Dudley decomposed the 10-year Treasury yield into three estimates. First is r*, the "neutral" interest rate set by the Fed that neither hinders nor stimulates economic growth, which is set at 1%. Then there is the average long-term inflation rate: 2.5%. Finally, there is the term premium, which is the additional yield investors require to compensate for the risk of long-term loans, which is 1%. Therefore, the target yield is 1% + 2.5% + 1% = 4.5%.

Specifically, in a situation where interest rates are much higher than expected, the economy remains strong, indicating that the neutral interest rate is higher than previously thought. This has already been reflected in the forecasts of Fed officials. In the June "Economic Projections Summary," the forecast for the long-term federal funds rate has slightly increased.

The term premium is the most difficult part to predict. Before the financial crisis, it averaged around 100 basis points. Since then, it has been close to zero, largely because the risk is small: bonds are seen as a good tool to hedge against economic recession and the ineffectiveness of Fed monetary policy when interest rates are suppressed at the zero lower bound. Now, the threat of long-term inflation rising significantly may push the term premium back to the high levels before 2008.

In addition, growth, employment, and inflation will be the main driving factors. Overall, the pattern has changed, and higher yields have returned.

U.S. Stocks Face Downward Pressure

At the same time, the futures market shows that more and more people expect interest rates to continue to rise for a longer period of time, which puts pressure on the stock market.

Signs of continued strength in the U.S. economy, massive sell-offs of U.S. bonds, and expectations that the Fed may maintain higher interest rates for a longer period of time have pushed U.S. Treasury yields to the highest level in over a decade. In recent days, the yield on 10-year U.S. Treasury bonds reached a high of 4.339%, the highest since 2007, far exceeding the 3.956% at the end of July. And the "anchor of global asset pricing," the rise in US bond yields will push up the borrowing costs of the entire economy and reduce the prices that investors are willing to pay for investments based on future cash flow valuations, such as stocks.

This upward trend has intensified concerns that the overall valuation of the stock market is too high. The AI boom and increased economic confidence have driven the US market higher this year, but the growth in corporate profit forecasts has been relatively modest. The strong growth in stock prices has made market valuations appear excessive compared to historical levels.

James St. Aubin, Chief Investment Officer of Sierra Mutual Funds, pointed out:

The US stock market is indeed in a difficult situation. They have been elevated to a level where the price-to-earnings ratio has significantly expanded, and the fundamentals must validate this valuation judgment is correct.