The Relationship Between S&P 500 P/E Ratios and US Interest Rates

As a follow up to our more comprehensive 2017 paper and 2018 paper, this paper will strictly focus on the historical and current relationship between the S&P 500 P/E Ratio and US Interest Rates, updated to November 2022.

The P/E ratio can be described as the ratio between current share price and per-share earnings.  Earnings in the S&P 500 are calculated using the 12-month earnings per share of “current” earnings.  A higher P/E ratio suggests that investors expect higher earnings growth in the future.

During the period January 1971 to November 2022, the S&P 500 P/E ratio averaged 19.9x, while the median S&P 500 P/E ratio was 18.3x.[1]  The S&P 500 P/E ratio as of November 16, 2022 was 20.6x, which is slightly higher than the historical average of 19.9x.[2]  This ratio is currently in the 62^nd percentile of the historical distribution.

It is important to understand that returns can be estimated as changes in the P/E ratio and changes in earnings; therefore, factors that drive changes in the P/E ratio will also drive stock returns.

P/E ratios have demonstrated an inverse relationship to interest rates.  Given recent interest rate hikes and expectations for the Federal Reserve to continue to increase rates, at least in the short-term, P/E ratios are likely to decline.

However, only 22.4% of the variability in P/E ratios can be explained by the regression with interest rates, where interest rates (i) are the independent variable and P/E ratios are the dependent variable.

When we test the current federal funds rate of 3.83%, our equation predicts an S&P 500 P/E ratio of 21.5x – very close to the current P/E ratio.

[1]      Based on monthly data from multpl.com.

[2]      July 2022 through November 2022 P/E ratios are estimates.

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