Stock market investors can be forgiven for worrying that uncertainty could derail the aging bull market, but the market has an ace up its sleeve: low interest rates.
Historically, stocks do better when interest rates are low, and although rates have drifted up a tad they’re still quite low by historical standards. The 10-year U.S. Treasury note, for instance, yields a scant 2.2 percent, compared to 4 percent or more before the financial crisis. That makes it easier for investors to stomach a relatively high price-earnings ratio for stocks — current price divided by company earnings over the previous 12 months.
“With the 10-year bond currently yielding less than 2.5 percent, one can justify a much higher price-to-earnings ratio on stocks,” says Robert Johnson, president and CEO of the American College of Financial Services and co-author of “Strategic Value Investing: Practical Techniques of Leading Value Investors.”
[See: 10 Long-Term Investing Strategies That Work.]
Though the P/E on the Standard & Poor’s 500 index is north of 20, compared to a long-term average around, 15, that’s OK when interest rates are low, Johnson says.
“Pundits make a significant mistake when they look at P/E ratios and suggest that they are high or low based on history,” he says. “Paying 20 times earnings for a stock when interest rates are 8 percent is much different than paying 20 times earnings for a stock when interest rates are 2.25 percent.”
The relationship between rates and stock returns is complex, and it’s hard to predict how things will play out on any given day, week or month. But the principles are fairly straightforward.
Most important is an investor’s option of putting money into either stocks or bonds. When bond yields are as stingy as they are today, stocks look more attractive by comparison. Higher demand can hold stock prices up, or drive them higher.
To drill a little deeper, any investment is actually a way of purchasing future income. You put money into a bank or a bond to earn interest. Similarly, a share of stock gives its owner the right to share in the company’s future earnings, just as if you bought a ma and pa grocery store.
This is so even though most companies do not pay all of their earnings out to shareholders. Some of those profits may be invested in research and development, buying new equipment or buildings, or buying back shares to reduce the number in circulation. All of those strategies are meant to make shares more valuable. But since there must be earnings for any of those strategies, earnings and expected earnings are the foundation of share value.
So the price of a share reflects what investors are willing to pay for every dollar of per-share earnings. This is “earnings yield,” or earnings per share divided by share price — the inverse of PE ratio.
If the company earned $2 a share and shares traded at $40, earnings yield would be 5 percent (the same as a P/E of 20). If the firm did pay all that as dividends, a 5 percent yield would be very generous next to the 2 percent paid by the 10-year Treasury, and an investor might choose the stock even though it was riskier than the bond. The lower the bond yield, the easier it would be for stocks to compete. A 3 percent earnings yield would still look pretty good while a 1 percent yield would not. Low or falling interest rates make stocks more attractive and boost prices.
[See: 10 Skills the Best Investors Have.]
Other factors come into play as well. Low interest rates, for instance, make it cheaper for companies to borrow money, helping to boost profits and pushing up share prices. Of course, low rates can hurt companies like banks that lend money, but since most companies are not lenders, low rates generally prop up the stock market.
Low rates also make it cheaper for consumers to borrow, which can boost sales of goods and services, adds Paul Koger, founder of trading site FoxyTrades.com.
Higher rates have the opposite effect.
“Investors generally view this as a bad sign for business profits, which hurts stock market returns,” says Anthony D. Criscuolo, portfolio manager with Palisades Hudson Financial Group in Fort Lauderdale, Florida. “Overall, the more expensive money becomes via higher interest rates, the less money will be used in the aggregate economy.”
While low interest rates are good for stocks, rising rates hurt both stocks and bonds. As new bonds become more generous, investors will not pay as much for older ones with low yields, so bond prices fall. As bonds become more generous, stocks have a harder time competing, so rising rates undermine stock prices.
Also, future earnings are less generous in real terms when interest rates are higher. A 5 percent earnings yield that looked great when rates were 2 percent, doesn’t seem worth the risk when bonds yield 4 or 5 percent. So investors are less willing to pay a premium for every dollar of earnings. That puts downward pressure on share prices.
Johnson explored these principles in “Invest with the Fed,” which he co-authored with Gerald Jensen of Creighton University and Luis Garcia-Feijoo of Florida Atlantic University.
“From 1966 through 2013, the S&P 500 gained 15.2 percent when rates were falling and only 5.9 percent when rates were rising,” Johnson says. “Now, that doesn’t mean that stock returns have historically been negative as rates have risen. But, it does show that the return on stocks is much lower in a rising-rate environment than in a falling-rate environment.”
While the Federal Reserve raised short-term rates slightly in 2015 and 2016, and plans to raise some more this year, the moves are modest.
“In most cases, rising rates are only bad for the economy when they are rising too fast,” Koger says.
Johnson says energy, consumer goods, utilities and food stocks have done best when rate rise, but he warns against making major investment changes due to expected rate changes.
[See: 9 Ways to Buy Stocks That Everyone Needs.]
“I believe that long-term investors should have a target asset allocation and should stick to that target asset allocation whether rates are rising or falling, and whether the stock market is rising or falling,” he says. “We are oftentimes our own worst enemies when we try and time the market.”
More from U.S. News
9 Food-Focused ETFs to Feed Your Portfolio
10 Out-of-the-Box Ways to Save Money
Stock Investors Find Safety in Low Interest Rates originally appeared on usnews.com
