John Hussman: Low Interest Rates Don't Fuel Expensive Stocks

Excerpt from fund manager John Hussman's weekly essay on the U.S. market:

Investors have come to believe that low interest rates are a good thing for stocks in general, when in fact they are only a good thing if stock valuations are cheap. Importantly, low interest rates are of no help to stocks when stock valuations are rich. Contrary to the bad intuition that the Fed Model instills in the minds of investors, relatively low interest rates (at least on the basis of 10-year bond yields) are not nearly sufficient to justify or offset the negative effect of rich stock valuations.

Specifically, when stock valuations have been above average (again, defined here as just roughly 14 times the highest level of trailing net earnings achieved to-date) and interest rates have been low (below 6% on the 10-year Treasury yield), overall market performance has been tepid regardless of the trend of yields. In the 16% of history when we've observed high valuations with low and falling interest rates, the S&P 500 has achieved an average annualized total return of 6.22%. Combining high valuations with low and rising interest rates (which has occurred just as often), the average annualized total return has been 5.41%. Average returns have been even lower when valuations have been above 18 times record earnings, as they are today.

"Fed Model" intuition also fails investors in the case where interest rates are high and stock valuations are cheap. While the Fed Model would view this situation as fairly neutral, better intuition suggests that this sort of condition can be very desirable. Specifically, when stocks are relatively cheap and yields are high, there is a great deal of room for yields to decline and stock valuations to expand. We should therefore expect stock returns to be quite strong, given a combination of cheap valuations and high interest rates, as soon as we have evidence that interest rates are trending lower (even based on a comparison with levels of 6 months earlier). This better intuition is correct. The S&P 500 has achieved annualized total returns averaging 26.46% from such conditions, which have historically occurred about 14% of the time...

Investors should not simply assume that low interest rates are "good" and high interest rates are "bad." The facts are much more subtle. Historically, stocks have performed well, on average, when valuations have been relatively cheap, and interest rates have been low, falling, or both... In general, high stock valuations coupled with low interest rates (as we have now) have historically been symptomatic of a fully priced, overly optimistic market, with little margin for error.

Comments

[leow.cathy]

I disagree violently with your opinion. Low interest rates help all stocks regardless of their p/e's. Low interest rates, means money is cheap and companies can profitably invest and expand their businesses. That is true regardless of whether their p/e is high or low. The only advantage I see to a low p/e stock vs. high one is that the management can profitably buy back stocks if money is cheap.