Interest Rates, Earning Growth and Equity Value: Investment Implications
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The relationship btw interest rates and equity values is complex and influenced by the underlying causes of rate changes, such as growth or inflation.
Aswath Damodaran, "Interest Rates, Earning Growth and Equity Value: Investment Implications,"Musing On Markets, March 25, 2021, http://pages.stern.nyu.edu/~adamodar/
Bottom line, "... There is a surprisingly complicated relationship between interest rates and stock prices, with higher interest rates sometimes coexisting with higher stock prices and sometimes with lower.As rates rise, though, the effects on value will vary across companies, with some companies being hurt more and others being hurt less, or even helped. To understand why, I will draw on one of my favorite structures, the corporate life cycle, where I argue that most companies go through a process of birth, growth, aging and ultimate decline and death. To see the connection with interest rates, note that there are two dimensions on which companies vary across the life cycle: Cashflows: Young companies are more likely to have negative than positive cash flows in the early years, as their business models are in flux, economies of scale have not kicked in yet, and substantial reinvestment is needed to deliver the promised growth. As they mature, the cash flows will turn positive, as margins improve and reinvestment needs drop off. Source of value: Drawing on another construct, the financial balance sheet, the value of a company can be broken down into the value it derives from investments it has already made (assets in place) and the value of investments it is expected to make in the future (growth assets). Young companies derive the bulk of their value from growth assets, whereas more mature firms get their value from assets in place. Connecting to the earlier discussion on interest rates and value, you can see why increases in interest rates can have divergent effects on companies at different stages in the life cycle. When interest rates rise, the value of future growth decreases, relative to the value of assets in place, for all companies, but the effect is far greater for young companies than mature companies. This will be true even if growth rates match increases in interest rates, but it will get worse if growth does not keep up with rate increases...."
Aswath Damodaran on the relationship btw rising rates and stock values, highly situational, "...the effect of rising rates on stock priceswill depend in large part on the precipitating factors. If rising rates are primarily driven by expectations of higher real growth, the effect is more likely to be positive, as higher growth and margins offset the effect of investors demanding higher rates of return on their investments. If rising rates are primarily driven by inflation, the effects are far more likely to be negative, since you have more negative side effects, with risk premiums rising and margins coming under pressure, especially for companies without pricing power...."
His example, "...To see how changes in interest rates play out in equity markets, I started with a simple, perhaps even simplistic adjustment, where I look at quarterly stock returns and T.Bond rates at the start of each quarter, to examine the linkage. While the chart itself has too much noise to draw conclusions, the correlations that I have calculated provide more information. The negative correlation between stock returns and rate changes in the prior quarter (-.12 with the treasury bond rate) provide backing for the conventional wisdom that rising rates are more likely to be accompanied by lower stock returns. However, if you break down the reason for rising rates into higher inflation and higher real growth increases, stocks are negatively affected by the former (correlation of -0.078) and positively affected by the latter (correlation of.087).It is also worthnoting that none of the correlations are significant enough to represent money making opportunities, since there seems to be much more driving stock returns than just interest rates, inflation and real growth. I also updated my valuation (from January 2021) of the S&P to reflect current rates and earnings numbers, and played out the effect of changing rates on the intrinsic PE ratio for the index: In making these computations, I looked at three scenarios, a neutral scenario, where changes in the T.Bond rate are matched by changes in the expected long term earnings growth rate, a benign scenario, where expected long term earnings growth runs ahead of the change in the T.Bond rate by 0.5%, in the long term, and a malignant scenario, where earnings growth lags changes in the T.Bond rate by 0.5%, in the long term. Note that in the best case scenario, at least with my range of outcomes, where rates drop back to 1.00%, but long term earnings growth runs ahead of riskfree rates by 0.5%, the intrinsic value for the index is 3919, just above current levels. In the worst case scenario, where rates rise to 3% or higher, and growth lags by 0.5%, the index is over valued significantly. Connecting to my earlier discussion of how inflation and real growth play out differently in earnings growth, I would expect a real-growth driven increase in rates to yield values closer to my benign ones, where an inflation-driven increase in rates will be far more damaging for stocks….”
Ed Comment:As you know, I believe the fed is more of rate taker than it tries to admit.“…. I would argue that the Fed has tried everything it can to keep rates from rising, and the very fact that rates have risen, in spite of this effort, is an indication of the limited power it has to set any of the rates that we care about in investing.…”
Note as a reminder he also views the Fed (at the end of the day) as a rate taker, not maker, “…. I would argue that the Fed has tried everything it can to keep rates from rising, and the very fact that rates have risen, in spite of this effort, is an indication of the limited power it has to set any of the rates that we care about in investing.…”