Why Interest Rates Matter For Your Stocks

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Includes: BF.A, HSY, K, KO, MO, O, T
by: Tim McAleenan Jr.

On December 31, 1964, the Dow Jones Industrial Average closed at 874.12. Seventeen years later on December 314, 1981, the Dow Jones Industrial Average closed at 875.00. Although the Dow Jones Industrials moved nowhere over this period of time, corporate America was booming during this time. GDP quadrupled (went up 370%) from 1964 to 1981, and the sales of Fortune 500 companies went up 600% over this time frame. The question naturally follows, if business growth was strong for seventeen years, how come the Dow Jones Industrial Average did not budge in price?

At a party hosted by Allen & Company in Sun Valley, Idaho, Warren Buffett gave the answer: rising interest rates. Buffett explains it as follows:

"We need to look at one of the two important variables that affect investment results: interest rates. These act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull. That's because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So if the government rate rises, the price of all other investments must adjust downward, to a level that brings their expected rates of return into line. The basic proposition is this: What an investor should pay today for a dollar to be received tomorrow can only be determined by first looking at the risk-free interest rate.

Consequently, every time the risk-free rate moves by one basis point (0.01%), the value of every investment in the country changes…In the 1964-1981 period, there was a tremendous increase in the rates on long-term government bonds, which moved from just over 4% at year-end 1964 to more than 15% by late 1981. That rise in rates had a huge depressing effect on the value of all investments, but the one we noticed, of course, was the price of equities. So there-in that tripling of the gravitational pull of interest rates-lies the major explanation of why tremendous growth in the economy was accompanied by a stock market going nowhere."

In some regards, the low interest rates of today may be a factor that could indicate that some excellent companies are overvalued. I've pointed out that Brown Forman's (NYSE:BF.A) valuation at 26x earnings, Kellogg's (NYSE:K) valuation at over 20x earnings, and Hershey's (NYSE:HSY) valuation near 30x earnings are noticeably above the average P/E ratios that those firms experienced over the past decade, but there's an added hitch: interest rates are lower today than they were throughout most of the 2000-2010 decade that I used as a reference point. That makes them even more expensive today on a relative basis.

It's also why I'd shy away from buying something like AT&T (NYSE:T), Altria (NYSE:MO), and Realty Income (NYSE:O) at today's prices. Although all three companies are incredibly stable cash generators, they are trading at the peak valuations compared to where they have been valuation-wise since 2000. Using historical tools, AT&T should be trading at 14x earning, Altria should be trading at 12-13x earnings, and Realty Income should be trading at a P/FFO ratio of 15-16. I suspect that when interest rates rise, we will begin to see this kind of reversion to the mean with these cash-generating stalwarts. That's why I wouldn't buy any of these three companies right now: when interest rates rise, the stock price performance of these three companies will likely lag the earnings growth of these firms as the valuation levels normalize.

Buffett's right to point out that the attractiveness (and valuation) of a company hinges on the prevailing interest rates. That 2.75% dividend from Coca-Cola (NYSE:KO) means something completely different when Uncle Sam is willing to give you 7% annual interest compared to when he's willing to give you 1% annual interest. With a few exceptions, there may be a good reason to be cautious about initiating new positions in many popular blue-chip stocks right now. Not only are many trading at levels above their historical P/E ratios over the past thirteen years, but this is coupled with an environment of record-low interest rates. When interest rates rise and P/E levels normalize, some investors may be seeing their companies grow by 9-10% but only receive 5-7% annual returns because of this "Reversion To The Mean" drag on prices.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.