We have had a nice rally since March 2009, when it seemed like the world was coming to an end. Major indices have more than doubled and seem to continue to be on a tear. What has been pushing this rally along in a world with a sluggish economy, political dysfunction and aftershocks from the greatest financial crisis in most of our lifetimes? The answer is really simple: it's the interest rate, stupid.
The unprecedented low interest rates which may have been viewed as temporary back in 2009 and 2010 have moved equities higher for several different reasons. They also have provided investors with a handy metric for assessing where the market is likely to go for nearly four years now. Here are the key reasons that interest rates are relevant.
1. Fundamental Valuation - Stocks reflect ownership in enterprises which generate cash flow. The cash flow is generated over time and a widely accepted method for estimating the present value of an enterprise is called "discounted cash flow." It involves estimating the future cash flow of the enterprise and then reducing the total future cash flow using a discount rate. Simple arithmetic demonstrates that the lower the discount rate, the higher the present value of any stream of future cash flow. Now, the discount rate isn't the prevailing interest rate, but it should be affected by the prevailing interest rate; what investors are willing to pay for a future stream of cash is really exactly what an interest rate is, and low interest rates reflect an investor willingness to pay a relatively high amount for such a stream.
This argument is so elementary that bears have had difficulty coming up with a plausible response. Two inventive arguments I have heard have been: 1. the low interest rates are "artificial" because they are the result of unprecedented Federal Reserve intervention, and 2. low interest rates reflect pessimistic assumptions about future growth of the US economy, and therefore, reflect pessimistic assumptions about future cash flows.
The problem with these arguments is that they are contradictory. I will concede that there is some merit to the second argument - low interest rates certainly reflect an assumption that inflation will be low and this, in turn, will tend to lower nominal future cash flows. The problem is that the argument about the "artificial" nature of low interest rates undercuts this point. If rates are low solely because of Fed intervention, then low rates do not necessarily reflect low expectations concerning future cash flows. We are left with a situation in which it seems reasonable to apply low discount rates to a careful estimate of future cash flows. This appears to be what the market is doing, as there are many fewer high multiple stocks trading at levels which assume explosive earnings growth than we have seen in some past bull markets. Interest rates are relevant if applied carefully, and they certainly help explain the current dynamics of this market.
2. Yield Hunger on the Part of Investors - Low interest rates make stocks relatively attractive in comparison to bonds and money market funds or deposits. An investor seeking to optimize yield can find certain yield oriented equity strategies that actually produce more yield than most fixed income strategies. I will be going through some of these in my Desperately Seeking Yield series of articles and they are common knowledge. BDCs, mortgage REITs, equity REITs, utility stocks, tobacco stocks, telecom stocks, and certain other categories of equities generate mid to high single digit and, in some cases, double digit yields hard to equal in the fixed income world. Many of these stocks have moved up sharply as would be expected. Other dividend paying stocks may be even more attractive for long term yield oriented investors because of a demonstrated history and a likely future of ever increasing dividends. Indeed, the S&P 500 now trades at a dividend yield higher than the interest rate on 10 year treasuries and dividends keep increasing.
3. Financial Engineering - Low interest rates create enormous opportunities for financial engineering. Companies can increase earnings per share by borrowing money and buying back shares as long as the after tax interest rate on the borrowing is less than the earnings yield (the inverse of the earnings per share) of the stock. I have written about this in more detail here. Similarly, companies can make earnings accretive acquisitions as long as the after tax interest rate on the borrowings used to finance the acquisitions is less than the earnings yield of the stock(at the acquisition price) of the target. Frankly, given the low interest rates, I have been surprised by the fact that there have not been more LBOs and acquisitions and also by the fact that many companies maintain enormous cash amounts on their balance sheets. On the other hand, this may suggest the potential for a huge wave of financial engineering going forward.
Metrics which ignore interest rates are likely to mislead investors in our current situation. Interest rates are not mechanically determinative of market valuations but they are definitely relevant and, at a time of extreme interest rates like the present, they may become the dominating force in the market.
Since the Fall of 2009, the S&P 500 has traded in a relatively narrow dividend yield range - between 1.78% and 2.20% - with most growth in the Index being explainable due to the increase in dividends; more detailed data is provided here. An investor who bought whenever dividend yield on the index got close to 2.20% would have done very well indeed. This range is not particularly low. The dividend yield of the index got above 3% in early 2009 as the market bottomed but it stayed below 2% for a long time between 1996 and early 2008. It is, right now, in the middle of the 1.78% to 2.20% range and dividends have been increasing. At some point major banks will start paying "normal" dividends and the total dividends paid by the index will go up significantly. These do not sound like the characteristics of a bear market.
Investors can still generate attractive yield with stocks like Two Harbors (TWO), Hercules Technology (HTGC) and Arbor Realty (ABR). Solid stocks with a history of reliable and growing dividends like Johnson & Johnson (JNJ), WalMart (WMT), Exxon (XOM) and Microsoft (MSFT) will in the long haul produce better returns than bonds even if purchased at this point in the rally.