Looking at stock returns over very long periods reveals two key determinants of price: Earnings and interest rates. While everyone will probably agree that earnings are important, many find the relationship between interest rates and stocks to be confusing. Many believe that low interest rates now are causing stocks to be bid up too aggressively and fear that the possible end of quantitative easing by the Federal Reserve could lead to a correction in the S&P 500 (SPY) or even a new bear market. Charts like this surely suggest we should fear the end of easy money:
This is from Jeff Gundlach's presentation this week. A quick glance at this chart, which shows how the market rallied every single time the Fed was engaged in QE, and it's obvious that the entire rally from 2009 has been built by Fed manipulation, right? I believe that correlation is at play, and not causation, but this is something that can't be proved. At a meeting with a client last week, we discussed the dynamics of QE possibly ending soon, and it was a somewhat heated debate. Reasonable people will arrive at different conclusions on this topic. While I certainly acknowledge that rising rates might have a negative psychological effect on stocks over a very short period of time (and I do think that rates will rise), I believe that rising rates, if they reflect improving economic growth, are what we should hope for!
Why Interest-Rates Are Important
Interest rates affect stocks in two ways. Competition for investor capital and a cost of doing business. Investors allocate capital to where they can achieve the best return relative to risk. As interest rates rise (and bond prices fall), this can serve to siphon off interest from stock investors. This is what I believe concerns those who fear the end of QE the most. Their thinking is that if interest rates rise at the margin, then investors sell stocks at the margin, but this is overly simplistic, as I will discuss below.
As far as how rising rates can hurt the earnings of corporations, this can play out in a number of ways. Most obvious is that borrowing costs rise. Of course, this assumes that companies are borrowing short term, as any debt that they have issued, unless it is floating, is locked in. While the typical company has net debt, there are many companies that would actually benefit from higher interest rates, as they are currently earning zero on their cash holdings. In fact, this will likely be the bigger story in my view -- trying to separate those companies that have positive exposure to interest rates from those who bear some risk.
Another way that rising rates can impact a company's earnings are that at the margin, it cuts back on investing in inventory or extending credit to customers (accounts receivable), as the cost of doing so becomes more expensive as interest rates rise. Similarly, CapEx decisions become more challenging, as the company requires higher returns from its investments. This is ultimately what can lead to economic contraction, as companies find that investing in working capital or in PPE becomes less attractive and curtails investment.
While both of these paths to pain are quite clear, it's important to remember where we are in the cycle. Interest rates are extremely low. Any rise in rates is likely to have little impact initially, as I will now describe.
Why A Rise In Rates Isn't Important For Now
Let's first look at the relationship between interest rates in stocks. Typically, this type of analysis requires that one do a calculation for stocks known as the earnings yield, which is essentially the P/E ratio inverted. I like this metric, but some will use dividend yield instead, though that is subject to variability in payout ratios. There are several different ways to do this, including looking at the spread (the difference) and the ratio. I prefer the former. Finally, there are many ways to compare the earnings yield of the S&P 500 to interest rates. While some use Treasuries, typically the 5-year or the 10-year, I prefer to use corporate bonds, as they capture some of the risk that should be reflected in equities.
I have to thank Scott Grannis (the Calafia Beach Pundit) for his recent article "Service Sector Muddles Along, But That's Good News", as he has saved me quite a bit of time with this chart:
While the S&P 500 earnings yield, which is currently near 6.5% has been above the Baa yield in the past, it has been quite some time until the recent experience. While I am not arguing that it should drop below the Baa yield as it did when rates were falling in the 80s and 90s, the point is that the gap is very large at about 250 bps. The stock market isn't stupid! It just has never bought into permanently low interest-rates.
If rates were to rise 100 bps, perhaps it might impact the P/E ratio a bit, but most likely not fully. Let's go through the math, but first, let's make an assumption that the reason rates are rising is because of improved economic growth and that this leads to a projected 10% rise in EPS.
First, let's take the extreme example that this historically wide spread holds and that the earnings yield rises from 6.7% to 7.7%. If we then calculate that ratio, we can see that the P/E goes from 15 (1 divided by 6.7%) to 13 (1 divided by 7.7%). The impact on stocks would be slightly negative. If earnings a year from now are 10% higher but the P/E has contracted by 13%), there is some price risk (about 3%).
A more realistic assumption, though, is that the spread between the earnings yield and the Baa yield would contract. If the P/E dropped to only 14 in this scenario, then the prices of stocks would rally by about 3%. If the P/E stayed the same, then stocks would follow earnings and rise by 10%. I might be crazy, but in this Goldilocks scenario of rising rates and improving economic growth, we could see the P/E expand. Why? Reallocation out of bonds! If the P/E were to expand to 16, stocks would return almost 17%.
Let's discuss now why it will take more than a small rise in interest rates to impact earnings. The number one risk to earnings is likely labor costs and not interest rates, but that's a different story. We currently have a lot of slack in the economy, so rising employment is still a good thing! Don't expect wages to rise substantially.
As I mentioned earlier, most large companies have already locked in low-cost, long-term debt. A rise in short rates would benefit companies with large cash balances, as they would be able to earn a return on their idle cash. If rates are rising because of stronger economic growth, then profits are likely growing. Unless rates rise faster such that they exceed what companies can earn on their investment in inventory or in productive assets, then they are unlikely to curtail investment. Later in the cycle, this could become an issue. It also can impact interest expense in the future as old debt rolls off and needs to be issued at higher rates. So, it's not just the rise in rates but also the passage of time that would lead us to need to consider this potential negative.
In my view, it's sheer fantasy that QE has "caused" the stock market to return to the levels from 2007, though I certainly haven't proven it. The Fed didn't cause the downturn, and it didn't fix it. While there is no denying that low interest rates have had a positive impact of allowing time for the economy to repair and that we should expect rates to rise somewhat when the economy improves, it is not logical to assume a model with only "good" (rates low) and "bad" (rates rising). Instead, investors should contemplate how the cycle of interest rates will impact stocks. Rising rates aren't bad, until they are bad. I learned this lesson in the Crash of 1987, as rates were rising all year and scaring investors, yet stocks continued to rally. As a reminder, the 10-year Treasury then had a double-digit yield. In the current environment of a sub-2% 10-year, we should hope for rising rates if they are a function of an improving economy. The impact of rising earnings will likely dwarf the negative effects of marginally higher interest rates until rates are "normal." For me, this means a 10-year of about 4%, or double the current level.
I do expect rates will rise, and I think that it will hurt parts of the market. If you own fixed income, I shared some advice in September about how you can reposition. If you own stocks that are like fixed income, they are at risk, and I discussed how you can protect your portfolio. The bottom line, in my view, is that investors will be better served by thinking about how to allocate within fixed income and within equities (and of course, between the two asset classes) than by worrying about overall equity exposure to rising rates, at least until interest rates are more normal.
Tactically, rising rates will likely prove to be an opportunity to buy stocks as investors are able to trade against the knee-jerk reaction. I still am maintaining my 1666 year-end target for the S&P 500 that I shared at the beginning of the year, but I am expecting a rotational correction to pull the market back into the 1530-1570 range (4-7% from the recent 1635 peak).