If I got a dollar for every time someone asked me about equity market valuations, I would be rich and retired by now. In a low Interest rate environment, and frankly one which may persist for some time, we felt it was important to discuss its effects on equity market valuations. The discussion relating to interest rates and the effect on economy is a whole different one and we will not talk about that there.
The easiest place to start this is with what we all know: Interest rate is the cost at which money can be borrowed and lent (not exactly, but for the sake of our understanding this is a good place to start). Equities are not priced in a vacuum; they are always compared to other alternatives. Through the course of this article, we will also mathematically try to explain how this happens. First let's discuss how interest rates affect the economy.
1. High interest rates hurt company profits - In a high interest rate regime, companies bear a high interest expense. This eats into company profits.
2. High interest rates reduce domestic participation in stock markets: Investors tend to keep their money in fixed deposits or fixed return assets when interest rates are high. Indian investors pulled out money from equity markets in 2012-13. In January 2013 when interest rates were high, mutual funds were net sellers to the tune of Rs 2,770 crore. In contrast, the current low interest rates in US and other markets drove foreign institutional investors to risky assets in emerging markets.
3. High interest rates slow growth: Future growth of companies and expansion is also affected due to persistent high interest rates. Companies struggle to repay existing loans and put on hold expansion plans. This results in fewer jobs than before. Companies also cut spending and consume less. This reduces the demand for goods and services and slows economic growth.
However, this needs to be taken with a pinch of salt, as a low interest rate regime has its own cons - one of them being Inflation. In low interest rates, consumers borrow more, spend more, leading to high inflation which forces the regulators to keep the interest rates in check. And, this vicious cycle of interest rates continues.
Around 10 years ago, let’s say the yield on 10 year treasury notes was 5%. To invest in equities, you would want an additional risk premium in excess of 5%. When this yield goes down (currently around 1%), it leads to a lower expectation from equities even with the same expected risk premium thus raising valuations.
Professor Robert Shiller has arguably the best long term data set for equity valuations over time; he popularised the CAPE Ratio (Cyclically Adjusted Price to Earnings Ratio). It is extremely simple to calculate:
CAPE = Share price/Inflation adjusted average EPS for the last ten years.
He displayed that there is significant inverse correlation over the long run. High interest rates generally result in low valuations, and low interest rates often lead to high stock valuations.
Low interest rates after major crashes like 1929 (year of the Great Depression), 2000 (Tech Crash) and 2020 (Covid) correlated with higher stock valuations. However, we must also point out that extreme scenarios like World War in the 1940s led to lower valuations despite low interest yields.
The P/E ratio, which is probably the most widely used metric for security analysis, is definitely impacted by interest rates and at best can be used for within sector comparison. There's always been an inverse relationship between interest rates and P/E ratios. When return for fixed income offerings declines, it makes sense to pay higher valuations for equities. When you think of it, the inverse of P/E is E/P or Earnings Yield. Ex: inverse of 40 P/E translates to 2.5% earnings yield.
When central banks are pumping liquidity into global financial markets around the world, stock prices tend to rise. So valuations tend to remain "challenging (read high). Lower interest rates have their most-powerful effect boosting P/E ratios of reliable growth stocks, for which the majority of their earnings lie far in the future.
Low interest rates according to Howard Marks mean markets have been shaped by optimism, faith in investing and investors, trust in future, low level of skepticism and risk tolerance, not risk aversion. Attributes like these, do not contribute to a positive climate for prospective returns and risk. The increase in risk tolerance leads to asset appreciation, but that doesn’t necessarily mean it makes the world safer.
To end with we would like to mention what Howard Marks said in his latest newsletter:
Investors who feel strongly about the risk of inflation in low interest rate regime, might wish to emphasise more on:
1. Floating rate debt.
2. Investments in businesses with largely fixed costs or the ability to pass on cost increases and/or
3. Situations where profits have the potential to grow faster than prices rise.
Until next time...
V.good writeup brother keep it up...