Interest Rates Affect Stock Valuations
Interest Rates affect the multiples on stocks. We all know that companies can grow earnings and dividends over time, while bonds offer a fixed coupon. In general, bonds and equities are parts of the opportunity set for investors. In other words, the typical investor allocates their portfolio between bonds and stocks, and possibly overweights the assets that may appear attractively valued relative to the other. Of course, interest rates are just one of the inputs in valuing businesses.
In the early 1980s, the P/E multiples on stocks were in the mid to high single digits – as low as 7. This represents an earnings yield of roughly 14%. At this time however, long-term bonds yielded as much as 15%/year. There were several well-known investors such as Warren Buffett and Peter Lynch, who have said that at a 15% bond coupon issued by US treasury, it makes more sense to invest in bonds rather than stocks.
In 2016, stocks have an average P/E that is a little over 20 times expected earnings. This represents an earnings yield of roughly 5%. At this time however, long-term bonds yield less than 2% – 3%. These low interest rates have pushed investors into stocks, because bonds offer a worse deal for long-term returns.
Interest rates affect cost of capital for companies, and thus affect profits. If interest rates are high, interest expenses will be high, and thus profits lower. In addition, companies will have less projects that make sense to finance at those high rates. Therefore, profits will be depressed.
If interest rates are low however, companies will have lower interest expenses, which translates into higher profits. In addition, because the cost of capital is lower, companies will be able to finance more projects. Therefore, profits will be helped.
I am discussing interest rates, because this has been a topic that has been on my mind for several years. You may not remember, but back in 2008- 2009, a lot of people believed that TARP and all the stimulus would be inflationary and interest rates would be increasing. This belief has been on-going for 8 – 9 years now, but hasn’t been accurate. This has prompted me to ask myself what to do about low interest rates in 2011, in 2013 and 2014. The fear of potential interest rates hikes was wrong in retrospect – so I am glad I generally avoided it. Of course, I didn’t do this because I am a smart macroeconomic genius. I did it because I focused my attention on businesses which sell products or services that are more stable and sticky, and which could be reasonably expected to grow those sales, earnings and dividends over time. This could ultimately bail out a patient long-term business owner even if interest rates increase ten times from here.
A lot of investors today talk about how all stocks are overvalued. This has been the case since 2009 at least too. US stocks are selling at a little over 18.60 times forward earnings ( and 24.90 times trailing 12 months earnings), which is historically on the expensive side. The problem with this statement however is that investors do not really have a decent alternative where to put money to work. If you purchase S&P 500, you will earn a dividend yield of 2%, and a dividend payment which will likely grow above the rate of inflation over time. You may also earn some decent capital gains, if earnings grow and the valuation multiple does not shrink by too much.
If you purchase a 10 year US treasury bond today, and hold to maturity, you will not make more than a 1.50% – 1.60%/year. This implies a P/E ratio above 60. Even 30 years US Treasuries yield no more than 2.40% today, which is equivalent to a P/E ratio of 40. And as we all know, bond coupons do not grow – but earnings streams could grow. Source: WSJ
The situation is even worse abroad, where certain countries have long-term bonds that have negative yields. For example, the 10 and 30 year Government Bonds from Switzerland have negative interest rates. This means that borrowers pay the Swiss Government for the privilege of lending money to that government over long periods of time. It is quite possible that this happens in the US, and bonds get to zero or negative interest rates as well.
In comparison, Nestle (NSRGY) spots a dividend yield of 2.80%. The company has a business model that is as close to recession proof as possible. I highly doubt that people will stop eating food, just because interest rates have turned negative.
You can see that stocks look like better investments relative to bonds today. It makes sense that if you have a certain amount of cash today to invest, you can earn a much better rate of return on stocks.
It also looks as if there is some “margin of relative safety” in stock valuations relative to bonds. For example, if bonds yield 4% or 5% today, stocks can still have a P/E of 20. A P/E of 20 is equivalent to an earnings yield of 5%. So in other words, even if bond yields on 10 and 30 year US treasuries double from here, valuations on stocks would not be affected by much. And to be honest, I do not see how the FED would raise interest rates in the short-term, when the world is increasingly at negative interest rates. When they ultimately have to raise rates, I believe that those would be gradual increases. But even if they are not, stocks can withstand some shock up to 4% – 5% rates. This is because stocks represent fractional ownership pieces of real businesses, which can tend to grow revenues, earnings and dividends over time, as they become more productive, invent new products, expand markets etc. So the real defense mechanism for stock investors against rising interest rates is the fact that earnings can grow, which can offset the impact of those rising interest rates.
Incidentally, I try to avoid overpaying for stocks by looking only at those companies that have a P/E below 20. Therefore, this should prevent me from chasing hot growth stocks, and somewhat isolate my losses in the event that we have a P/E compression over the next decade.
If however bond yields remain low for extended periods of time, stocks may go higher. While this will never happen, Buffett has stated in an interview with CNBC that “If the government absolutely said interest rates are going to be zero for 50 years, the Dow would be at 100,000” (Source: CNBC)
The only way that bonds are better investments over the next decade or two is if we have a deflationary spiral which pushes earnings, dividends and share prices down the drain. During the Great Depression from 1929 – 1932, bonds provided stability in a portfolio. During the last 27 years in Japan, bonds did better than stocks. Over the past decade, European stocks have gone nowhere, while bonds provided pretty good returns. This is the scenario that I am not prepared for very well.
My fixed income exposure ( cash, CD’s, bonds, savings accounts) is in the 10% – 15% range of total net worth for me. If I were retired and eligible for Social Security, I would view this as part of my fixed-income allocation. Since I am still young at this time, I do not expect my fixed income exposure to increase above 20% – 25% of net worth in the next decade for me. If I were retired however, I would not want to have less than 25% of net worth in fixed income, despite the poor prospects for returns in this asset ( unless I am deriving a substantial portion of income from Social Security). This is something I have discussed a lot before. The thing that has always stopped me from owning too much fixed income were always the low yields. ( which have since gone even lower).
Full Disclosure: Long Nestle