The Effect of Interest Rates on Stock Valuations Is Exaggerated

The Effect of Interest Rates on Stock Valuations Is Exaggerated
Megan_Rexazin / Pixabay

I am always making the case that people need to pay more attention to stock valuations when deciding on how much to invest in value stocks. An argument that I frequently hear in response is that valuations today are not really so bad when you consider the effect of the low interest rates that apply today. When interest rates are low, the super-safe asset classes offer poor returns. So people feel a need to put their money in stocks. Thus, the thinking goes, high stock valuations are natural at such times and not a cause for alarm.

low interest
Megan_Rexazin / Pixabay

I have never been persuaded by this argument. But I have seen some very smart people, including some people who in general are more open than most to acknowledging that valuations matter, make the case. So it made me happy to see Robert Shiller address the question in an article that he recently published in the New York Times.

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Is There A Relation Between Interest Rates And C.A.P.E. Ratio?

Shiller wrote that: “People will point this year to low interest rates to justify the high C.A.P.E. ratio. But interest rate levels historically have not correlated well at all with the C.A.P.E. For example, low long-term rates did not explain the high C.A.P.E. ratios in 1929 and 1999, nor did rising long-term interest rates explain subsequent market crashes.”

That to me is how you go about testing a theory that you have re how the stock market works -- you check the historical record. It makes sense to believe that low interest rates cause high stock prices. It’s a plausible theory. But, when we are putting our retirement money at risk, we need more than a plausible theory to guide us. Given the poor historical correlation between low interest rates and high stock valuations, I am not willing to buy into this theory.

So why do so many smart people find merit in it?

Low interest rates and buy and hold

The entire Buy-and-Hold concept is rooted in a belief that investors make rational choices when buying stocks. There is no research showing this to be the case. It is an assumption, nothing more. In fact, there is a lot of evidence pointing in the other direction. The entire advertising industry exists because it is known (not by the same people as the people who developed the Buy-and-Hold concept,to be sure!) that consumers (the people who buy stocks) are heavily influenced by emotions when making purchase decisions.

The idea that interest rates influence stock valuations is just one more in a long list of things that we believe because it makes sense. It DOES make sense. But we know from Shiller’s Nobel-prize-winning research that the stock investing realm is not a realm where logic and rationality and reason prevail. It is a realm where emotion prevails, especially at a time like today, when stock valuations are off the charts. We need to learn to discount beliefs that are the product of our desire to flatter ourselves by portraying ourselves as the reasoning animal.

We cannot abandon the use of logic in analyzing investment topics, obviously. Shiller does not recommend that and I do not recommend that. What we need to do is to not jump to hasty conclusions based on arguments that fail to take investor emotionalism into account. Do you know what you will find if you search the historical record to learn how people justify insanely high stock valuations? You will find that -- it’s always something.

Justifying High Stock Prices

Sometimes we justify high prices by pointing to low interest rates. At other times, we point to exciting technological breakthroughs that promise years of accelerated productivity. At yet other times, we note that we appear to have entered a time of political stability that will permit us all to enjoy unusual good times for an extended stretch of years. It’s always something.

The humans like high stock prices. The true explanation for them is no more complicated than that. It is we human investors who determine what the price of stocks is and we like it to be high because we count the high prices that we assign to stocks as real and we like the feeling of having more money in our accounts that goes with a decision to overprice this asset class.

High stock prices are an emotional phenomenon. Logic has nothing to do with it. Once we start trying to explain high prices by constructing logical rationales for them, we undercut the warning that the high valuation levels are trying to send us and make the high prices more dangerous than they would be if were properly alarmed by them.

High stock prices are dangerous. Anything that makes us worry less about them hurts us. So we should listen to Shiller and stop trying to rationalize today’s sky-high valuation levels by making reference to the low interest rates that also happen to apply today.

Rob’s bio is here.

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Rob Bennett’s A Rich Life blog aims to put the “personal” back into “personal finance” - he focuses on the role played by emotion in saving and investing decisions. Rob developed the Passion Saving approach to money management; Passion Savers save not to finance their old-age retirements but to enjoy more freedom and opportunity in their 20s, 30s, 40s, and 50s - because they pursue saving goals over which they feel a more intense personal concern, they are more motivated to save effectively. He also developed the Valuation-Informed Indexing investing strategy, a strategy that combines the most powerful insights of Vanguard Founder John Bogle and Yale Professsor Robert Shiller in a simple approach offering higher returns at greatly diminished risk. Tom Gardner, co-founder of the Motley Fool web site, said of Rob’s work: “The elegant simplicty of his ideas warms the heart and startles the brain.”
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