BULLS & BEARS: Understanding the effect of increasing interest rates

Interest rates are a major variable in the evaluation of any investment, whether it’s stocks, bonds, real estate … you name it. As interest rates change, they alter the value of all financial assets.

Simple mathematics shows that, as interest rates rise, the present value of a dollar to be received tomorrow is worth less to an investor today. Thus, when interest rates rise, the prices of all investments move down in value. And conversely, when interest rates fall, investment values are pushed upward.

Investors can clearly view this relationship in the bond market, where the level of interest rates is the predominant factor in determining bond prices. With stocks and other types of investments, there are other important factors that figure into the value equation. Still, shifting interest rates exert their force on all investment values.

From 1964 to 1981, the interest rates on long-term government bonds soared from 4 percent to 15 percent. This had a depressing effect on the value of all investments. Even though the U.S. gross domestic product rose nearly fivefold during this period, the stock market went virtually nowhere.

Since the early 1980s, the opposite has occurred. Long-term government interest rates began their long descent from 15 percent to nearly 3 percent in the spring of 2003. Of course, during this stretch, stock investors experienced the greatest bull market in history.

Interestingly, though, economic growth during the great bull market was not as strong as during the 1964-1981 period. The GDP during 1981-1999 didn’t quite triple, yet the stock market rang up 19 percent annualized rates of return through the market high in spring 2000. The explanation for this is that a powerful component of the bull market’s investment returns was the prolonged decline in interest rates.

Trying to read the tea leaves, which we never advocate doing on a short-term basis, it doesn’t seem like much of a stretch to anticipate that the Federal Reserve’s campaign to raise short-term interest rates will eventually spill over to higher long-term government interest rates. Should this occur, the tailwind stocks have enjoyed would indeed turn into a bit of a headwind.

With long-term government bonds yielding in the 4.5-percent range at present, it is instructive to look at how competitive stocks are with the risk-free return. To do so, it is useful to look at the inverse of the price-to-earnings ratio often called the “earnings yield.”

With the aggregate stock market trading at a P/E of 20, the earnings yield on stocks is about 5 percent. This tells us broad market investors are receiving a 5-percent return on corporate earnings at today’s market levels, hardly what we would consider a bargain.

None of this is to suggest that investors should sell all their stocks and go into hibernation. Long-term investors will benefit with time, as American business continues to grow over the long haul. However, investors may have to deal with the occasional market dislocation and be content with investment returns that are more muted than in the salad days of the 1980s and 1990s.

As always, remaining patient and preserving capital for attractive investment opportunities should serve an investor well.