How Interest Rates Impact Stock Prices

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There are only two ways that stock prices can move higher. Via increased company earnings, or via an increase in the ‘multiple’ investors are willing to pay for those earnings. This multiple is generally referred to as the price-earnings (P/E) ratio.

For example, when times are good and investors are (deliriously) optimistic, ‘the market’ might trade on a P/E of 20 times. That means investors are willing to pay $20 for every dollar of earnings a company makes.

But when things aren’t so good, the market might trade on a P/E of 10 times or lower.

Now, it doesn’t take a mathematician to see that if the market moves from trading on a multiple of 10 times to a multiple of 20 times, it will increase in price 100%, without earnings having to increase a cent.

Generally though, when earnings increase, so does the market multiple. Rising earnings, then, usually result in strong share price gains.

BHP is a good recent example of how this works at the company level. The chart below shows that it bottomed in January 2016 at $14 per share. Just recently, it hit a peak of $28 per share.


Source: Bigcharts
Click to enlarge

That’s a 100% increase in 12 months.

The price move is a combination of a change in earnings and a change in the multiple investors are willing to pay for those earnings.

BHP’s share price is now experiencing a bit of a correction. The catalyst for the latest pullback was a rise in interest rates — in China.

That’s because China’s economy has a big impact on commodities, BHP’s stock in trade. When interest rates change in China, it has an effect on commodity producers’ earnings (via lower expected commodity prices) and leads to more cautious sentiment.

This brings me to one of the main determinants of the ‘market multiple’ — interest rates. The rate of interest is like an anchor for stock prices.

Are stocks in a bubble?

Going back to the earlier example, a P/E of 20 means investors are willing to pay $20 to obtain $1 of company earnings. Put another way, that’s a 5% earnings yield (1/20).

Is the prospect of getting a 5% earnings yield from stocks attractive? It depends. As Einstein pointed out, everything is relative.

If you can get a 5% return by putting your cash in the bank for very little risk, then it’s not a good return at all, and stocks are clearly overvalued. But if the interest rate is 1%, and bonds yields are, say, 2.5%, then perhaps stocks are reasonably valued at 20 times.

So next time you hear someone say that stocks are in a bubble and are crazy overvalued, ask them: compared to what?

More than likely, that person is simply imposing their personal judgement on the market. Because THEY think stocks are overvalued, they think the market IS overvalued.

That’s fine to state as an opinion, but not as a fact. Because the small investor doesn’t move the market. What they think doesn’t matter. It’s the investing giants who effectively set asset prices.

When you’re managing tens of billions of dollars, you have two major choices: stocks or bonds. You can’t afford to sit in cash and wait for prices to become more favourable. So it’s stocks or bonds, and the relative value between these two asset classes will determine your choice.

The biggest determinant in the absolute value of both stocks and bonds is interest rates. This is why the market goes nuts over analysing the decisions of the US Federal Reserve. It’s decisions matter for the value of assets globally.

RBA to keep rates on hold

The rest of the world isn’t so concerned about what the RBA does, but you should be. Its decisions have a major impact on Australian assets prices, from bonds to stocks to house prices.

The RBA meets today to decide on interest rates. Chances are that newish governor Phillip Lowe will keep rates on hold at 1.5%.

But you’d have to expect that he’ll start to warm the market up for a rate rise at some point this year. That’s because commodity prices — and especially iron ore prices — have rebounded strongly this year. When that happens, it boosts Australia’s ‘terms of trade’, which in turn boosts our national income.

Given the decline in interest rates to historic lows was largely because of the plunge in commodity prices from 2011–2016, it would make sense for rates to pick up along with commodity prices.

But there are some good reasons why the RBA will be reluctant to increase rates.

Firstly, it’s hard. Rate cuts are easy. But it’s much harder to make the case for a pre-emptive rate hike in an economy that has been weak for years.

Secondly, the economy is pretty much addicted to low rates now. The whole point of the rate cutting cycle was to ignite a housing boom, to keep the economy afloat during the commodity downturn. It certainly did that. This in turn boosted the housing construction cycle and consumption.

But consumption is now waning and the construction boom is slowing. An interest rate rise would take more heat out of these markets and leave the economy reliant on an iron ore price recovery that may be about to run out of puff.

For these reasons the RBA will remain cautious and keep rates on hold. But watch for a hint that a rate rise is coming down the track. If that happens, don’t be surprised to see the market fall.

It’s simply succumbing to the theory of relativity.

Regards,
Greg Canavan

About Greg Canavan

Greg Canavan is a Feature Editor at Money Morning and Head of Research at Fat Tail Investment Research.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

That is, investing in the Information Age means you have all the information you need…

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