I have been examining the connection between interest rates and equity valuations, and have discovered that the relationship is more complex than generally understood. First of all, there is reason to believe that interest rates on corporate bonds, rather than on treasuries, are what should be relevant to equity valuations. If treasury rates are very low but there are enormous spreads on corporate bonds (as there were in late 2008 and early 2009), this situation will not support high equity valuations.
Similarly, if rates are understood to be low only for a very short period of time, it is unlikely that this phenomenon will have much effect on equity valuations. On the other hand, if spreads are reasonable and rates are low and if it is perceived that rates will stay low for a considerable period of time, this will tend to support higher equity valuations.
I think that there are three fundamental reasons for this, and that an understanding of these reasons will enable investors to best take advantage of the extraordinarily low interest rate situation we find ourselves in.
The first reason is the one which is most widely understood to be relevant: Investors will accept a lower dividend or earnings yield on equities because their only alternative is to accept a low return on fixed income securities or money deposits. It is not hard to understand why a stock with a reliable dividend yield of 3% is attractive in a world with zero interest rates. It is also true that the earnings yield -- the inverse of the price/earnings ratio -- of a stock can be compared to the interest yield on a bond, and, depending upon the perception of risk and the perception of growth, an earnings yield of 5% (which implies a PE of 20) does not look too bad in this bond market.
So there will definitely be a tendency of investors to bid up prices of stocks to levels more consistent with bond yields. I do not think that the "Fed Model" -- under which earnings yields should equal yields on 10-year treasuries and which would predict a PE of roughly 30 -- is accurate. I would look more at yields on 5-7-year BBB bonds for reasons that will become clear later in this piece -- but even these yields are in the 4-6% range and would imply PEs bewteen 17 and 25. We are definitely seeing increasing signs of "yield hunger" and "low interest rate fatigue" on the part of retail investors, and they are helping to push the stock market up.
Less widely understood is the connection between very low interest rates and financial engineering. Low interest rates make it much more attractive for companies to use excess cash (which would otherwise earn a low return) or to borrow (at very low after-tax interest rates) in order to implement a share repurchase program. We have seen that Wal-Mart (NYSE:WMT) is doing this at a rate which could produce significant increases in per-share earnings.
Share repurchases push the market higher in two ways: They reduce the number of shares in the market and they increase earnings per share. Financial engineering can also take the form of refinancing debt at lower interest rates and thereby increasing earnings; Coca-Cola (NYSE:KO) seems to have recently accomplished this.
In addition, a company can pay a relatively high PE for an acquisition and still increase its earnings substantially if the acquisition is financed with very low interest debt, as EasyLink Services International Corp. (NASDAQ:ESIC) has recently done. Cash-for-stock acquisitions push the market higher by removing shares from the market, increasing speculation in potential target companies and increasing the earnings of the acquiring company. What is really relevant to financial engineering is not the interest rate on treasuries, but the interest rate that companies actually have to pay to borrow money to implement these actions. I think that rates on BBB bonds with maturities between five and seven years are a good proxy for the cost of the borrowing that would typically accompany the above types of financial engineering.
Much less well understood is the tendency of the PE metric to understate the private market value of certain companies in a very low interest-rate environment. In such an environment, there will be a tendency for the ratio of free cash flow to earnings to be higher, because depreciation will be higher relative to capex; free cash flow is generally considered to be more relevant to private market value than earnings.
In addition, companies with large amounts of cash as a percentage of market cap will tend to be undervalued because, in a low interest-rate environment, the cash produces very little in the way of earnings, and thus tends to inflate the PE to a much higher number than the EPEE (the price earnings ratio of the enterprise itself independent of balance sheet cash). In the cases of Cisco (NASDAQ:CSCO), Microsoft (NASDAQ:MSFT), and Intel (NASDAQ:INTC), this has the effect of producing a PE roughly 20 percent higher than the EPEE and obscuring how cheap the enterprise is actually priced in the stock market, once the enormous hoards of cash on the balance sheets of these companies are backed out.
Low interest rates affect different equities in different ways but there are a number of very compelling reasons to believe that they generally support higher valuations.
Disclosure: I am long KO, CSCO, MSFT, INTC, WMT, ESIC.