If you invest in stocks, you should know these 2 things about interest rates

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The financial media pays plenty of attention to interest rates. We just have to look at the amount of commentary that pops up whenever central banks around the world make their interest rate decisions.

If you invest in stocks, like us at The Good Investors, there are two things about interest rates and their implications that you should know.

1: THE REALITY BEHIND THE RELATIONSHIP BETWEEN INTEREST RATES AND STOCK PRICES 

I’ve written about the theory behind how interest rates govern the movement of stock prices in a previous article. Here’s the relevant excerpt:

“Stocks and other asset classes (bonds, cash, real estate etc.) are constantly competing for capital. In theory, when interest rates are high, the valuation of stocks should be low, since the alternative to stocks – bonds – are providing a good return.

On the other hand, when interest rates are low, the valuation of stocks should be high, since the alternative – again, bonds – are providing a poor return.”

But in the same article, I also pointed out that things are different in real life:

“There’s an amazing free repository of long-term US financial market data that is maintained by Robert Shiller. He is a professor of economics and the winner of a Nobel Prize in economics in 2013.

His data includes long-term interest rates in the US, as well as US stock market valuations, going back to the 1870s. The S&P 500 index is used as the representation for US stocks while the cyclically adjusted price earnings (CAPE) ratio is the valuation measure. The CAPE ratio divides a stock’s price by its inflation-adjusted average earnings over a 10-year period.

Contrary to theory, there was a 30-plus year period that started in the early 1930s when interest rates and the S&P 500’s CAPE ratio both grew. It was only in the early 1980s when falling interest rates were met with rising valuations.”

2: BASED ON HISTORY, INTEREST RATES HAVE DECLINED AS A COUTNRY DEVELOPS 

Josh Brown is the CEO of Ritholtz Wealth Management. In a June 2019 blog post, Brown recounted a dinner he had with the polymath investor William Bernstein. During the dinner, Bernstein posed a question that had been in his mind for awhile: What if the cost of capital never rises again? (The cost of capital refers to the cost of money – in other words, interest rates.)

Bernstein’s question is fascinating to think about. That’s because a broad look at history shows us that interest rates have declined as countries mature. Here’s Bernstein on the subject in his book, The Birth of Plenty (I highly recommend it!):

“Interest rates, according to economic historian Richard Sylla, accurately reflect a society’s health. In effect, a plot of interest rates over time is a nation’s “fever curve.” In uncertain times rates rise because there is less sense of public security and trust.

Over the broad sweep of history, all of the major ancient civilisations demonstrated a “U-shaped” pattern of interest rates. There were high rates early in their history, following by slowly falling rates as the civilisations matured and stabilized. This led to low rates at the height of their development, and, finally, as the civilisations decayed, there was a return of rising rates.”

THE IMPLICATIONS

There are two implications I can draw from the relationship between interest rates and valuation, as well as Bernstein’s data on how interest rates change with the growth of countries.

First, Shiller’s data show that changes in interest rates alone cannot tell us much about how stocks will move. “If A happens, then B will occur” is a line of thinking that is best avoided in finance. The second implication is that it is possible for interest rates in the US and other parts of the world to stay low for a very long period of time. That’s history’s verdict.

I also previously wrote:

“Time that’s spent watching central banks’ decisions regarding interest rates will be better spent studying business fundamentals. The quality of a company’s business and the growth opportunities it has matter far more to its stock price over the long run than interest rates.

Sears is a case in point. In the 1980s, the US-based company was the dominant retailer in the country…

… US long-term interest rates fell dramatically from around 15 per cent in the early-to-mid 1980s to 3 per cent or so in 2018. But Sears filed for bankruptcy in October 2018, leaving its shareholders with an empty bag. In his blog post mentioned earlier, Housel also wrote:

“Growing income inequality pushed consumers to either bargain or luxury goods, leaving Sears in the shrinking middle. Competition from Wal-Mart and Target – younger and hungrier – took off.

By the late 2000s Sears was a shell of its former self. “YES, WE ARE OPEN” a sign outside my local Sears read – a reminder to customers who had all but written it off.”

Warren Buffett’s Berkshire Hathaway provides an opposite example to Sears. From the start of 1965 to the end of 1984, US long-term interest rates climbed from 4.2 per cent to 11.5 per cent, according to Shiller’s data.

But a 23.7 per cent increase per year in Berkshire’s book value per share over the same period resulted in a 27.6 per cent annual jump in the company’s share price. A 23.7 per cent input led to a 27.6 per cent output over nearly 20 years, despite the significant growth in interest rates.

You may also be wondering: What’s going to happen to global financial markets in a world that is awash in cheap credit for a long time?

We can learn something from Japan: The country has already been in a situation like this for decades. The yield for 10-year Japanese government bonds has never exceeded 2 per cent going back to the fourth quarter of 1997, according to data from the Federal Reserve Bank of St Louis. 

Interestingly, Japan’s main stock market index, the Nikkei 225, is just 40 per cent or so higher from October 1997 to today, despite interest rates in the country having declined from an already low base in that time frame.

Yet, there’s a company in Japan such as Fast Retailing – owner of the popular Uniqlo clothing brand – which has seen its stock price increase by more than 11,000 per cent over the same period because of massive growth in its business.

From the year ended 31 Aug1998 (FY1998) to FY2019, Fast Retailing’s revenue and profit grew by around 27 times and 56 times, respectively.  

WHAT IT ALL MEANS FOR STOCK MARKET INVESTORS 

So to wrap up everything I’ve shared earlier in this article:

  1. Rising interest rates may not hurt stock prices by depressing valuations, as seen from the S&P 500’s CAPE ratio increasing from the 1930s to the 1960s while interest rates were rising.
  2. Historically, interest rates have declined and stayed low as countries develop and mature, according to William Bernstein’s book, The Birth of Plenty.  
  3. Falling interest rates cannot help a stock if its business is crumbling, as seen in the case of Sears.
  4. Rising interest rates also would not necessarily harm a stock if its business is flourishing, as Berkshire Hathaway has demonstrated.
  5. The example of Japan’s Nikkei 225 index show that persistently low interest rates don’t always benefit stocks too. 
  6. Fast Retailing’s experience highlights how Individual stocks can still be huge winners even in a flat market, if their businesses do well over time. 

And what do all these mean for us as stock market investors? It means that we shouldn’t bother with interest rates. Instead, we should focus on the health and growth of the businesses that are behind the stocks we own or are interested in. In other words, watch business fundamentals, not interest rates.

This article was first published in The Good Investors. All content is displayed for general information purposes only and does not constitute professional financial advice.