While this chart only goes back to 2005, you can see that the P/E remained rather flat through much of the first part. It was the continuing upward pressure the Treasury Rate added to the sum that pushed it over into the bearish zone.
P/Es have been contracting for quite a while now. Interest rates have been falling for much of the last 12 months, too. The combination has reversed the RV from quite high risk to quite low. Of course this all assumes the P/E holds up going into a rough patch in the economy.
With interest rates now nearing the 1% mark, if we assume the middle of the Neutral zone to be about 21, then P/Es can rise to 20 before we've even started to recognize any stress. Now, P/E can rise two ways: 1) Earnings can drop off dramatically while stock prices stay the same. 2) Stock prices could rise dramatically while earnings remain the same.
Which of these two are more likely to play out? That's anybody's toss of a coin. However, it's likely that a bit of both will be in there when the final analysis is done. If earnings remain flat and P/E rose to 20, that would mean about a 66% rise in stock prices on average! That would put the S&P 500 back around 1400+. Well, that's why I think it will be a combination.
Hope this helps clarify how the RV works and the relationship of the short Treasury rate and P/E. In the past we've had interest rates of 12% and a P/E of 9 and it still adds up to about 20 so is a "neutral" market. We've also had P/E of 20 and nterest rates of 1% - also adding up to a neutral market. So, history shows that when interest rates are high, P/E's usually head lower and visa versa. Negative correlation. It's also true that the market will ignore rising interest rates for a long time before they realize the situation.
In 2002-03 at the market bottom, the sum was well below the "bullish" threshold. It is again right now.
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