The conventional wisdom among investors suggests that low interest rates are favorable for equities. The assumption holds true with regards to profits and leverage. However, theory tells a different story, as do the performance of two key metrics: earnings yields (how much a company earns per share) and dividend yields (ratio of annual dividend to share price).
- In the early 20th century, higher earnings yield was accompanied by pessimistic growth expectations and higher risk premiums. Today, constant and low earnings yield and darkening growth expectations affect equity valuations.
- In the U.S. and Japan, earnings and dividend yields were decreasing simultaneously with interest rates. Nevertheless, they climbed up when interest rates reached a historically low territory. This behavior hints at gloomy growth expectations, suggesting investors need to adapt to the challenging environment.