A low interest rate environment is always going to be favorable for stock valuations. As Warren Buffet, the well known value investor is often quoted: “Interest rates are to asset prices what gravity is to the apple. When there are low interest rates, there is a very low gravitational pull on asset prices.” In a recent television interview (CNBC, May 2017), Buffet explained how this works:
“The most important item over time in valuation is obviously interest rates (…) If interest rates are destined to be at low levels (….) it makes any stream of earnings from investments worth more money. The bogey is always what government bonds yield (…) Any investment is worth all the cash you’re going to get out between now and judgment day, discounted back. The discounting back is affected by whether you choose interest rates like those of Japan (i.e. near zero) or interest rates like those we had in 1982…. When we had 15 percent short-term rates in 1982, it was silly to pay 20 times earnings for stocks.”
When Buffet refers to “20 times earnings” as a measure of relative value, he is speaking of the relationship between the price of a security and the earnings of the underlying business. This is what investors call the price earnings ratio (P/E for short), or simply the earnings “multiple”. The price earnings ratio has long been used as a quick way to determine if a security is fairly valued or not. Generally speaking, the higher the “multiple”, the more an investor pays for every dollar of current earnings, and the more richly-valued the security becomes.
After a decade of extremely accommodative monetary policy, stock valuations have increased disproportionately to actual corporate earnings. As such, current stock market “multiples” have been significantly higher than historical averages, suggesting that stocks may be over-valued. But, in the same 2017 television interview, Buffet surprised listeners by declaring the stock market to be “dirt cheap”, if only the low level of interest rates were guaranteed for another 10, 15 or 20 years! Of course, no such guarantees exist, and there in lies the current conundrum for stock investors.
Now that interest rates are rising, stocks are necessarily beginning to experience that “gravitational pull” again. Without the support of more stimulative monetary policy, either corporate earnings will have to move higher, and/or stock prices will have to adjust downward. So as 2018 came to a close, with the pace of economic growth slowing amid heightened trade tensions between US and China, it is small wonder that investors balked at the latest round of interest rate hikes in December.
What is interesting to note in the current market context, is the extent to which the extreme monetary policies since 2008 have caused disconnect between stock values and the underlying economy. This has been particularly apparent In the US, where stock prices soared, propelled by the zero interest rate policy of the Federal Reserve, despite the fact the economy was still struggling to recover after the financial crisis. Now we are seeing the opposite phenomenon. Despite relative strength in the economy, the stock market has been all about doom and gloom as though we were headed into much more difficult times than the leading economic data actually suggests. Such is the transition back to “normal” monetary policy, and it will necessarily mean plenty more market turbulence ahead, one way or another.
