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Robert Abbott
Robert Abbott
Articles (360)  | Author's Website |

‘The New Buffettology’: How Interest Rates Affect Stock Prices

Warren Buffett watches the relationship between rates and stock prices

September 13, 2018

The connection between interest rates and stock prices gets a workout in chapter eight of “The New Buffettology.” Authors Mary Buffett and David Clark began by explaining Warren Buffett (Trades, Portfolio)’s belief that all investment returns compete with one another. At the time their book was published, stocks competed with bonds.

Buffett knows businesses are worth what earnings they will bring in over the time the security is owned. In a perfect world, stock prices would match the value of the underlying businesses; in reality, share prices sometimes get ahead of that value, and sometimes they fall behind. Still, a business can only be worth what it will generate over time.

The authors share this example:

  • An AAA corporate bond pays 10%, meaning you would need to buy $1 million worth of bonds to give yourself an annual income of $100,000.
  • If it costs $1.5 million to buy a business (stock) that brings in $100,000, then its return would be 6.7%.
  • If you put that same $1.5 million into bonds, the annual income would jump to $150,000—and at 10%, a much better deal for the investor.

In this 10% bond case, you would obviously buy them rather than the business. However, you might consider buying the business if the price dropped to $1 million, where it would have the same yield as the 10% corporate bonds.

Since the bonds produced a better yield than the business, there would have been downward pressure on the price of the business. On the other hand, if the bond yield dropped to 5% and a million-dollar investment would only yield $50,000, the business would have become a better prospect, causing upward pressure on the price of the business.

Put simply, every fluctuation of the interest rate produces a fluctuation of business valuation, in the opposite direction.

Interest rates are set by the Federal Reserve, which generally ignores the prices of businesses (i.e., stocks). The Fed is concerned only with fiscal policy, increasing rates when the economy becomes heated (in part, because of rising stock valuations) and decreasing them when the economy slows.

These changes by the Fed work as intended because the financing costs of businesses drop when rates are lower and increase when rates go up. Of course, the relationship between interest rates and business growth and decline sometimes get out step; this is especially acute when bubbles form because the market jumps into momentum investing and becomes less concerned about earnings.

What are these bonds we keep discussing? Buffett benchmarks (or did benchmark) potential investments against 10-Year Treasury Bonds; they yield much less in 2018 than when "The New Buffettology" was written in 2002. However, these bonds have other uses.

Investopedia says, "The importance of the ten-year treasury bond yield goes beyond just understanding the return on investment for the security. The ten-year is used as a proxy for many other important financial matters, such as mortgage rates.”

They are also considered an important indictor of investor confidence. When confidence is high, the price declines and yields go up since investors believe higher returning securities are available and they are not too concerned about safety. But when confidence is low, investors seek safety, driving up the price of the bonds and bringing down yields.

Bond prices and yields are also affected by the time to maturity since investors demand higher yields for longer commitments and greater uncertainty. More detailed information about treasury bonds is available at the U.S. Department of the Treasury website.

GuruFocus members now have access to a chart of 10-Year Treasury Bonds, which have a current yield of just below 3%:

10 Year Treasury Bonds chart

This chart can be accessed by going to an interactive chart page for any stock and scrolling down the menu on the left side of the page. Click on “Economic Indicators” and select “10 Year Treasury Constant Maturity.” Remove other chart selections to focus on the Treasury chart.

About

Buffett and Clark are the authors of “The New Buffettology: The Proven Techniques for Investing Successfully in Changing Markets That Have Made Warren Buffett the World’s Most Famous Investor.”

(This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.)

About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995, and in 2010 added options, mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the Unseen Revolution. In Big Macs & Our Pensions: Who Gets McDonald's Profits?, he looks at the ownership of McDonald’s and what that means for middle class retirement income.

Visit Robert Abbott's Website


Rating: 5.0/5 (2 votes)

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Comments

Thomas Macpherson
Thomas Macpherson premium member - 2 months ago

Great stuff Bob. I recently wrote about the impact of the Fed's prime rate and its impact on valuation. Interest rates and valuation are a grossly underestimated (and understood) part of investing. Always enjoy reading your stuff. Best. - Tom

Robert Abbott
Robert Abbott premium member - 2 months ago

Thanks for your helpful comments, Tom!

For those who have not read this excellent article, I recommend going here: https://www.gurufocus.com/news/701960/the-federal-reserve-and-valuations

LwC
LwC - 2 months ago    Report SPAM

“If you put that same $1.5 million into bonds, the annual income would jump to $150,000—and at 15%, a much better deal for the investor.”

I’m confused about that. Wouldn’t a $1.5 million investment that made $150,000/yr be a 10% yield? I guess that you still had the $1.0 million investment in your mind when you wrote it.

Robert Abbott
Robert Abbott premium member - 2 months ago

Thanks, LwC, you are correct about the number and my state of mind. I will correct it right away. Best wishes!

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