The Link Between Interest Rates And Stock Prices


“ In finance, one of the most fundamental laws we have is that the level and movement of interest rates will almost universally affect asset prices, with higher rates pulling down prices like the force of gravity, to use Warren Buffett’s simile. The Fed’s communications regarding lower rates have therefore caused market participants to start valuing the earnings streams of companies, and therefore their shares, at higher levels. This will affect companies not just in the US, but all over the world, because not only do we operate in highly integrated global financial markets, but US interest rates also happen to be used as a reference rate across all of them .”


 

The above was from the Smithson Trust report describing the relationship between interest rates and the stock market. To keep it short, lower interest rate when cause the stock market to go higher whilst an increase in interest rates will cause the stock market to go lower, at least in the short term.

 


Below is a thread from the excellent Chamath Palihapitiya who further underlines this relationship.

 


Some people scratch their heads when they see valuations of stocks justified by 2024E or 2025E numbers. Their instinctive reaction is to be dismissive but that’s lazy thinking.
Here’s a secret hiding in plain sight…

 


Everything in the public markets are valued against a “risk free rate”. This risk-free rate is the safest way to make money and is what the government pays you via US bonds or other securities that have “zero default risk”. This is in quotes for a reason…

 


When you buy something (a stock, a bond, a house) you are implicitly or explicitly deciding to sign up for the return that it will give you vs the risk free rate which you could otherwise get.

I.e. do I buy $AAPL? Or buy a US 10-yr bond?

 


In 2000, when the 10-yr risk free rate was 6%, we had the top of the Tech Bubble. The bubble burst, in part, because you could get 6% from Uncle Sam.

 


Many companies with hi flying stock prices back then had revenue growth but no near term cashflow. This drove analysts nuts.

 

So at some point, enough people said:

 

“Why buy these stocks with no earnings when the US Government will pay me 6%?”
That became a better and better question. And when enough people asked this question, they sold their stocks (bubble burst) and bought bonds.

 

Now think about the similarities and differences with today.

 

The similarities are, to some, that we are, again, focused on long term growth and no near term cashflow.

 

The big difference, though, is that our risk free 10-yr rate in 2020 is now 0.66%(!!) vs 6% 20 years ago. HUGE!

 

If you sell an “expensive” stock today, what do you do? Buy bonds? But they no longer give you near term cashflow. So for many it’s better to own a stock (all stocks have an embedded option for future cashflow) vs a zero cashflow bond today with zero option value in the future.

But what about “zero default risk”? Isn’t that worth something?
In part, the Fed’s policies have eroded people’s trust that it is worth anything.
It’s more likely that $AAPL or $AMZN are zero default risk today than the USG.

 

When you put all of this together, it creates two trends:

 

1. People become open to looking further in the future for a company to deliver cash flows – hence pricing stocks on 2024/2025 models today vs when rates were 6% (those models were 2-3 yrs max).

 

2. Investors, frustrated with a worthless risk free rate, become increasingly biased to equities.
All of this can change quickly, especially if rates rise but we’ve just been told by the Fed
that they will be more permissive with low rates for the time being.

 

Summary:

1. Risk free rates are important.


2. Currently, risk free rates are ~0.


3. As rates go down, people tend to model equity returns over LONGER periods of time.


4. As rates go up, people tend to model equity returns over SHORTER periods of time.


5. Because of #2 right now, investors will likely own equities by justifying buying them using a 3/4/5+ year models.


 

Don’t be frustrated by it. Don’t be blind to it. Understand it. Good luck!