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Interest Rates And Stock Prices: It's Complicated!

Aswath Damodaran profile picture
Aswath Damodaran

Jerome Powell, the new Fed Chair, was on Capitol Hill on February 27, and his testimony was, for the most part, predictable and uncontroversial. He told Congress that he believed that the economy had strengthened over the course of the last year and that the Fed would continue on its path of "raising rates". Analysts have spent the next few days reading the tea leaves of his testimony to decide whether this would translate into three or four rate hikes and what this would mean for stocks. In fact, the blame for the drop in stocks over the last four trading days has been placed primarily on the Fed bogeyman, with protectionism providing an assist on the last two days. While there may be an element of truth to this, I am skeptical about any Fed-based arguments for market increases and decreases, because I disagree fundamentally with many about how much power central banks have to set interest rates, and how those interest rates affect value.

1. The Fed's power to set interest rates is limited

I have repeatedly pushed back against the notion that the Fed or any central bank somehow sets market interest rates, since it really does not have the power to do so. The only rate that the Fed sets directly is the Fed funds rate, and while it is true that the Fed's actions on that rate send signals to markets, those signals are fuzzy and do not always have predictable consequences. In fact, it is worth noting that the Fed has been hiking the Fed Funds rate since December 2016, when Janet Yellen's Fed initiated this process, raising the Fed Funds rate by 0.25%. In the months since, the effects of the Fed Fund rate changes on long-term rates is debatable, and while short-term rates have gone up, it is not clear whether the Fed Funds

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Aswath Damodaran profile picture
I teach corporate finance and valuation at the Stern School of Business at New York University. I am a teacher first, who also happens to love untangling the puzzles of corporate finance and valuation, and writing about my experiences. As a result, I happen to be at the intersection of three businesses, education, publishing and financial services, that are all big, inefficiently run and deserve to be disrupted. I may not have the power to change the status quo in any of these businesses, but I can stir the pot. Please note that the article that you are reading here was originally written on my blog and is republished in Seeking Alpha and other forums. Consequently, I neither track nor respond to comments here. I am sorry!   ==Editors' Note: Seeking Alpha monitors Dr. Damodaran blog and posts relevant articles on his behalf.

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Comments (15)

Wow - awesome discussion - thanks! Quick questions: 1) In the terminal value calc are you using real or nominal growth? I assume the latter since interest rates are nominal. 2) What earnings are you using? They don't appear to be TTM GAAP. 3) The implied P/E of the three scenarios ranges from 17-24, however the historic multiple is 15 using TTM GAAP earnings ("operating" or forecasted earnings have even lower historic multiples). Why isn't there a reasonable scenario that reflects historic multiples? Thanks !!!
Cornerstone Investments profile picture
Great article, thanks for sharing the wisdom!
jcurtin profile picture
So, if I understand, to make it worthwhile to invest in a given equity and take the risk, today I should require close to an 8% per yr increase in stock price appreciation?
bluescorpion0 profile picture
If you add up all the case examples, sounds like the odds are either flattish to down for the market.
Thanks for the great analytical article.

I just wanted to add that we are at a very unique time historically, relative to corporate income statement dynamics and long term interest rates.

As the cheap corporate debt (last 9 yrs)starts rolling off the balance sheet , it will have to be either paid down, or refinanced at higher rates. This will affect the intrinsic earnings portion of the calculation, and it will dynamically change as more of the accumulated debt rolls off in the next 5 years. So the discounted earnings model for corporate valuation is very simplistic given this unique point in history.

The massive scale of debt financed stock repurchasing will slow significantly as well (i.e. float will be affected).

There are many other factors as well, that will affect intrinsic corporate valuations moving forward in the "increasing interest rate" scenario, due to the very unique macro and micro economic climate that we are emerging from.
The amount of foreign cash held by US companies ($2.6T) is about the same as the amount of cash to be invested by all of the S&P 500 companies in 2018 in capex, share buy-backs, dividends, acquisitions, and R&D.

There is plenty of primer to help plow through higher interest rates.
Not sure. Companies were borrowing in the US to effectively "access" their overseas cash. If they use repatriation to buy back stock, pay higher dividends, etc. vs. paying down that debt they will end up with higher net debt load. That carries it's own issues.
ligap profile picture
When interest rates go up, stock prices should go down, right?
I’ve always been told that “Rates go up BOND prices go down. And, Stock prices go up.

Perhaps you could speak to this question?
what's behind Interest rates going up/down?

My limited outsider's view sees that there are hundreds of thousands of bonds paying dividends on their coupon rate. Some will expire next month and many have 20 to 30 years to go.
There seems to be some all-seeing entity that condenses all these securities down to a single INTEREST-RATE for news purposes. I've been told this rate is called an Imputed Rate, ie. Calculated from multiple inputs.

I'm hoping this number is more reliable than LIBOR posted rates.

My hope is that there are Imputed rates for 30 year, 20 yr, 10 yr and short term that everyone can look at before panicking over a single number.
Id be interested in seeing there is a link between low interest rates and high consumer / national debt
togu04 profile picture
Really great article, thanks for cutting through the fog, Aswath. I think I "get" the difference btw yields driven higher by inflation v. by growth now -- but what of yields driven higher by shrinking the money supply (i.e. the end of QE4ever)? Since the purpose of QE was to lower rates, and it did succeed at this while also at rallying the stock market without much growth (and real estate also). Well, then doesn't it follow that ending QE will cause rates to rise with stock and housing markets falling regardless of the other two factors?
It is time to fix the national debt. Our entitlement programs are out of control. The FOMC has kept the rates low, but that's because we are a reserve currency. When that changes we are in deep trouble. When inflation is greater than the borrowing rate like it was in the 80's; you end up with a run away train. Time to return to capitalism and less gov't give aways.
I generally agree with your concerns and conclusions. However, for almost all of the 1980’s interest rates, and real interest rates, were both very high. Inflation was higher than interest rates on and off from the late 1960’s through about 1980.
fishfryer profile picture
Nice write up, most times, with respect to interest rates, the tail does wag the dog.
Active Investor Alliance profile picture
A great article indeed. In terms of buyback as a form of return capital to the share holder, would buyback of stocks and buyback of bonds have similar or different effect?
Dale Roberts profile picture
Wow, great article and research, thanks. I hope I am ready for whatever arrives. Yes, the US will not set the yields on their Treasuries, though they can affect them by buying up their own stuff. We'll see what the buyers want in return for those bonds.

All said, US stocks are only 20-30% of our mix. We buy considerably more current earnings and dividends by way of the Canadian and International holdings.

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