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The Science of Hitting
The Science of Hitting
Articles (454) 

Interest Rates and Stock Prices

The impact of long-term interest rates on equity valuations, and what that means for forward rates of return

November 06, 2017

During a recent CNBC appearance, Warren Buffett (Trades, Portfolio) said the following about the relationship between interest rates and equity valuations:

“The valuations make sense with interest rates where they are. In the end, you measure laying out money for an asset in relation to what you're going to get back. And the number one yardstick is U.S. governments. And when you get 2.30% on the 10-year, I think stocks will do considerably better than that. So if I have a choice of the two, I'm going to take stocks at that point. On the other hand, if interest rates on the 10-year were 5% or 6%, you would have a whole different valuation standard for stocks.

Interest rates are gravity. If we knew interest rates were going to be zero from now to judgment day, you could pay a lot of money for any other asset. You would not want to put your money out at zero… It's been a powerful factor. And the longer it persists, the more people start thinking in terms of something close to the rates they've seen for a long time. The one thing I'm sure of is that over time stocks from this level will beat bonds from this level…

And everybody expects interest rates to change, but they've been expecting it for quite a while… If three years from now interest rates are 100 basis points higher, then stocks will still look cheap at these prices. If they're 300 or 400 basis points, they won't look cheap.”

As usual, Buffett has succinctly covered a lot of ground. The purpose of this article is to look at the relationship between interest rates and equity valuations – and the impact it has on forward returns once the valuation has “reset” to a higher level.

Let’s look at an example to get a feel for the math behind Buffett’s first comment (“In the end, you measure laying out money for an asset in relation to what you're going to get back”). We are looking at a business that will generate a stream of cash flows over the next 50 years (100% returned to investors each year) that starts at $100 and increases by 2% per annum.

In the first scenario, investors demand an 8% annualized return (IRR) from the investment based on a spread over the risk-free investment; let’s assume 300 basis points over a long-term treasury yield of 5%. Based on those assumptions, this business (stream of cash flows) has a fair value of $1,600. At that price, investors will earn the 8% per annum that they require for taking the incremental risk of owning something other than the risk-free bond.

In the second scenario, the yield on long-term treasuries permanently declines from 5% to 2.3%. If the spread between the risk-free rate and our investor’s return requirement is held constant at 300 basis points, our IRR – the required rate of return we demand when paying for this stream of cash flows – falls from 8% to 5.3%. As a result of this change, the price we are willing to pay for the business increases to $2,460 – more than 50% higher than fair value in the first scenario.

The takeaway is a lower hurdle rate allows us to justify a materially higher price for an identical stream of cash flows. In the real world, we have seen the hurdle rate decline because the yield on the “number one yardstick” – U.S. treasuries – has been stuck near historic lows for five-plus years.

In summary, lower interest rates justify higher equity valuations. Looking at the numbers, the implied multiple increased from 16 times to nearly 25 times (pretty significant multiple expansion). There is nothing new or shocking here; I think this point is widely understood by market participants.

So there is a clear argument for a higher valuation (and stock price). But what does that mean for our forward return expectations? As an investor, what should I expect after Mr. Market accounts for the lower hurdle rate and the stock price (or index level) increases from ~$1,600 to ~$2,500?

The discount rate in our calculation makes the net present value of our future cash flows equal to zero. That rate is unchanged over the measurement period. When we use (or accept) a lower discount rate, we are building in a lower expected (required) rate of return over the life of the cash flows (business). I am not sure that point is always appreciated. The next time you hear someone say lower interest rates justify higher equity prices, you should finish the sentence for them: “Lower rates justify higher equity prices because today’s gains are eating into future returns.”

If our stream of cash flows is unchanged, a higher starting valuation (stock market gains from multiple expansion) is ultimately a “cost” that results in lower forward rates of return. Those lower future returns are deemed acceptable by market participants since the alternative (long-term treasuries) have become less attractive as well. The point is that there is a clear trade-off between the starting valuation (price) and return expectations.

When someone measures equity prices against bond yields, it is important to appreciate what they are saying. We must remember to differentiate between relative valuations and absolute returns. Failing to make this distinction could prove costly for investors. Stocks can appear cheap on a relative basis and still be expensive on an absolute basis (by which I mean priced for significantly less than historic rates of return).

Finally, assuming rates will hold near current levels has a material impact on the fair value estimate for equities. If that assumption ends up being incorrect, investors may be in for a surprise. Here’s how Seth Klarman (Trades, Portfolio) put it in “Margin of Safety”:

At times when interest rates are unusually low, however, investors are likely to find very high multiples being applied to share prices. Investors who pay these high multiples are dependent on interest rates remaining low, but no one can be certain that they will. This means that when interest rates are unusually low, investors should be particularly reluctant to commit capital to long-term holdings unless outstanding opportunities become available, with a preference for either holding cash or investing in short-term holdings that quickly return cash for possible redeployment when available returns are more attractive.

Conclusion

If treasury yields muddle along in the low single digits, investors can justify paying a lot of money for a future stream of cash flows. The owners of common stocks should not expect historic rates of return in perpetuity if starting prices (valuations) adjust for this factor.

On the other hand, if long-term rates move materially higher and stock prices adjust to earn a spread above the long bond, equity investors could be in for a rude awakening. It seems ill-advised for investors to become more confident that rates will stay low in the future simply because they have been low in the recent past.

There is one additional factor worth considering that I've overlooked: does a period of materially lower long-term interest rates have any impact (positive or negative) on the future cash flows to be received by equity investors? That is a discussion for another day.

I will leave you with Buffett’s prediction:

“If three years from now interest rates are 100 basis points higher, then stocks will still look cheap at these prices. If they're 300 or 400 basis points, they won't look cheap.”

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct". I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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Comments

fung9815
Fung9815 - 2 weeks ago    Report SPAM

For interest rates to stay low, inflation has to stay low, and it seems like inflation is to stay low for quite awhile, if not structurally.

The Science of Hitting
The Science of Hitting - 2 weeks ago    Report SPAM

Fung - I have no idea where inflation will be in three months, let alone three years, so I'll have to defer to your thoughts. Thanks for the comment!

stephenbaker
Stephenbaker - 1 week ago    Report SPAM

<<stocks can appear cheap on a relative basis and still be expensive on an absolute basis>> Very true yet rarely discussed. Clearly, the best time to buy stocks is when they are cheap on both counts. Over the years when I was actively buying BRK, I used a similar (but not exactly the same) strategy - buy when the price was both cheap on an absolute basis as well as cheap as compared to the S&P 500 - Buffett's measure of choice. As history has shown, the strategy worked out OK. A "relative" basis works best when there are investment alternatives available other than equities and bonds. Buffett figured that out long ago when he began buying whole businesses. As usual, there is a lesson there. Thanks as always for an interesting article.

The Science of Hitting
The Science of Hitting - 1 week ago    Report SPAM

Thanks for the thoughtful comment and the kind words Stephen!

Lfabian10
Lfabian10 premium member - 1 week ago

The internet was the greatest deflationary force that mankind had ever seen. Now add in the advent of Artificial Intelligence and there is going to be an extremely long runway of low inflation. Add in the aging U.S. demographic and a Millenial demographic that hates to spend and the odds favor low rates for a long long time.

fung9815
Fung9815 - 1 week ago    Report SPAM

The Science of Hitting, thanks for your response. Actually, Lfabian10 summed it up quite nicely (I agree with everything he said). I think having a big-picture judgment on future inflation can be quite useful, especially when our topic is about the importance of interest rates to valuation.

The Science of Hitting
The Science of Hitting - 1 week ago    Report SPAM

Lfabian and Fung - Everything you guys said may be correct. But that misses what I'm trying to say in the article. This is really about the distinction between stocks being cheap on a relative basis (compared to bonds) versus on an absolute basis (by which I mean compared to the historic rates of return that people "expect" from owning stocks over the long run). My argument is that people may not sufficiently appreciate the distinction between the two (or what that means in numbers). I hope that clears things up. Thanks for the comments!

jtdaniel
Jtdaniel premium member - 1 week ago

Hi Science,

Great article. I don’t interpret Mr. Buffett’s comments to preclude the possibility of a significant market correction, even if interest rates stay low for a few years. There are always other factors in play, whether for a single business or the general stock market. Best, dj

The Science of Hitting
The Science of Hitting - 1 week ago    Report SPAM

Jtdaniel - Completely agree. Thanks for the comment!

snowballbuilder
Snowballbuilder - 1 week ago    Report SPAM

Hi Science interesting article and topic

"This is really about the distinction between stocks being cheap on a relative basis (compared to bonds) versus on an absolute basis (by which I mean compared to the historic rates of return that people "expect" from owning stocks over the long run)."

"Great article. I don’t interpret Mr. Buffett’s comments to preclude the possibility of a significant market correction, even if interest rates stay low for a few years. There are always other factors in play, whether for a single business or the general stock market. Best, dj"

Fully agree with both.

I remember Buffett & Munger dedades ago saying many time that you act ONLY IF and WHEN there is a major opportunity. If there are not you simply WAIT. How long are we willing to wait? indefinitely.

They had became extremely rich and severely crushed the market looking patiently only for major opportunity (major BOTH in relative and absolute term)

TODAY Berkshire is different.

BRK (who has 400 bln of mkt cap, 80 bln of cash, blns of free float , positive quartely cash in and 3 investment manager Buffett , Ted and Tods) has made billions of investments in many different companies at any different time,,, they are (my opinion) looking for any deal that have a good spread between the expected return and their cost of capital. For example BRK has invested billions in regulated alternative energy producer and wind and solar power. They made good and fixed return on asset which convert to more than good BRK equity return as for BRK really low cost of funding (again low interest rate and free float). I understand and is fully rational for BRK.

But is not necessary the best way for a private value investor with lot of courage and lot of patience

Just some thoughts. Best snow

The Science of Hitting
The Science of Hitting - 1 week ago    Report SPAM

Snow - Agreed. Thanks for the comment and the kind words!

hansitburrun
Hansitburrun - 1 week ago    Report SPAM

This concept is what I call the "commnunicating vessel" and when one of the bassin is skewed (by QE) the massive (cheap) capital flow path is skewed too. Bond retrun needs to get attarctive t wake up the bond vigialnts!!

stephenbaker
Stephenbaker - 1 week ago    Report SPAM

Snow, decades ago you got paid 5 or 6 per cent risk free to wait. Not so today.

Cogito
Cogito premium member - 1 week ago

Being invested about 50% in US large caps and 50% in German small caps, I wonder how one could extend this discussion to two markets? While the Fed has begun quantitative tightening, the European ECB will continue QE at least until 2019. I wonder: will different interest rate expectations in the US and EU markets be compensated primarily via FX rate changes and how will the interconnectedness of the markets affect accepted valuation multiples in both markets. Can anyone recommend articles / papers / books on this question? (And P.S.: Thanks you, Science, for the great article and insight!)

P.P.S: For example: I would assume that rising interest rates in the USA might affect valuation multiples of US large caps less strongly than valuation ratios of US small caps. This is because EU investors (who will accept high valuation ratios, based on the European low interest environment) are more likely to buy US large caps than US small caps and thus might support high valuation ratios for US large caps even if US interest rates rise.

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