Saturday, December 16, 2017

Why rising interest rates may mean a lower stock market

Let’s explore the idea of future investment returns. Guys like Jeremy Siegel have stated that historically U.S. stock markets have returned 6% plus inflation annually.  That is of course a gross generalization. Often returns are linked to interest rates plus a ‘risk premium’ when investing in stocks. Leverage has always been an important part in the calculation of return on equity, in other words earnings per share.

Warren Buffett often speaks of earnings yield, which are the earnings per share divided by the share price. Basically the equivalent to interest or earnings earned on the principal of a bond or other types of loans. In fact, earnings yield is nothing more than the inverse of the price-earnings ratio of stocks. So here we have a direct relation between stock prices or valuation with interest rates.

If interest rates rise, typically investors would demand higher corporate earnings for each dollar invested or better a higher earnings yield. Thus with rising interest rates the P/E ratio or price-earnings ratio should fall. If earnings would be stable, then with higher interest rates the earnings yield should go up as well which means that stock prices would come down. So really, to maintain our stock price  we would need higher earnings and to get increasing share prices we would need even higher earnings. 

There are al kinds of financial earnings tricks to increase earnings beyond just increased sales. But increased interest rates means often a better economy; so does higher inflation. Nominal earnings growth goes along with inflation and also earnings growth (higher margins) goes along with an improved economy. If earnings (after having paid out dividends) would be used to buy back stocks rather than reinvestment in the company then earnings per share are likely to increase as a result.

So increasing interest by itself does not mean that stock prices would fall, but it would mean that a lower market valuation, i.e. lower P/E ratios would have to be offset by higher earnings per share. That of course is not a given and if earnings actually fall because of higher interest payments on outstanding debt matters would become even more difficult.

So all things considered, higher interest rates don’t necessarily mean a lower stock market but the odds of getting stable or lower earnings definitely increases and if so that is likely to result in lower stock markets.

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