Interest rates continue their decline as a result of the ECB's quantitative easing
For quite some time now, the interest rate that governments, companies and households pay on loans has been going down. Against the backdrop of this global interest rate drop, the European Central Bank (ECB) has been purchasing bonds at a large scale since the beginning of 2015 in an effort to reach its inflation target. This policy is also known as quantitative easing and has further brought down interest rates in the euro area. The policy creates favourable financing conditions, but also causes an increase in equity valuations, because the present value of future profits goes up as interest rates go down.
Search for yield
Due in part to the quantitative easing, investors get paid increasingly less for safe investments such as government bonds. For many European government bonds they even have to pay extra , as is evident from the negative interest rates against which government bonds are being traded. Consequently, investors are inclined to make ever riskier investments to ensure positive expected returns. This effect is known as the search for yield. Although this search for yield is one of the intended effects of quantitative easing, investors receive less compensation for the higher risk to which they are exposed. After all, investments with a low risk profile that yield the desired return are no longer available. This increases the risk of overvaluation for risky investments, such as equities.
Strong increase in price/earnings ratio
The DNB study used the Schiller method for the price/earnings ratio to get a picture of the valuations in the equity markets. This measure plots the real price of a share against the real average profit over the past ten years. This measure is therefore an indicator for the value of a share adjusted for the relevant phase of the economic cycle. A higher price/earnings ratios could indicate overvaluation, whereas a lower value could point to undervaluation of a share. This is only an indication. A high price/earnings ratios can for instance also be explained by the lower rates and/or because profit expectations for the coming years are higher than the average over the previous ten years.
After calculating the price/earnings ratio, the study uses a statistical test to determine whether the changes in the price/earnings ratio are stronger than could be expected based on the underlying factors. The method used says something about the change in prices around the announcement of quantitative easing, not about the absolute price levels.
Quantitative easing is accompanied by a strong increase in equity valuation
The application of the test on the price/earnings ratios for ten European equity indices shows that, since the start of quantitative easing, there have been periods in which equity valuations increased faster than could be expected based on the underlying factors. In addition, the study points to a significant correlation between strong increases in equity valuations and the introduction of quantitative easing. In most countries the equity valuations increased strongly in anticipation to the announcement of the quantitative easing programme in January 2015. Figure 1 shows the periods in which this significant increase of equity valuations was observed in the Dutch equity market.