Portfolio management
Long term rates and stock prices
A well know market pundit wrote: “The most important variable to the stock market, by far, is the direction of long-term interest rates.”
In today’s post I propose to examine this statement. The statement sounds quite wise and knowledgeable. In fact, it has zero usefulness to the thoughtful investor.
The future direction of long-term interest rates
Investors today are fussing over what the Fed will do in coming months with short term interest rates. The stock market is supposed to be forward looking. So, it’s all too tempting to think that if you could get a reliable forecast for lower rates over the coming year it would be profitable to invest in the stock market. The flaw of course is that everyone else is thinking the same thing and future rate cuts are probably already discounted. No, sadly, investing is not that easy.
But the wise words were about long-term rates. Let’s try the same exercise with long term rates. You might figure that the Fed is shrinking its balance sheet, engaging in Quantitative Tightening and thus might push up long-term rates over the next year even as short-term rates come down (or not). But, wouldn’t that make stock prices go down. And wouldn’t that be the opposite of the impact short term rates. This kind of wondering, of course, is a fool’s game. No one can predict the future. It invites an investor to try to time the market which leads to big trouble.
Let’s turn to Warren Buffett on the subject. In the in the Berkshire Hathaway Chairman’s letter for 1988 Buffett wrote: “As regular readers of this report know, our new commitments are not based on a judgment about short-term prospects for the stock market. Rather, they reflect an opinion about long-term business prospects for specific companies. We do not have, never have had, and never will have an opinion about where the stock market, interest rates, or business activity will be a year from now.”
So, here we have it from someone who knows. We shouldn’t be investing based on the outlook for interest rates, the economy or the stock market.
The past direction of long-term interest rates
Our pundit friend quoted above was talking about the direction of long-term interest rates. If we refuse to make investment decisions based on our speculations about the future direction of long-term interest rates, are we on firmer ground interpreting the past?
Take a look at a chart of US 10-year Treasury yields over the last five years.
Long-term yields were at a five year low in July of 2020. It is clear that the direction of long-term interest rates over the last three years has been up. So, what has happened to stocks in that three-and-a-half-year period? The S&P 500 is up some 62% since July of 2020. So, stocks were rising smartly in a period when long term rates were rising!! Aren’t stocks supposed to react badly to rising long term interest rates?
We can look at two quotes from Warren Buffett to make sense of this.
The first would seem to be contradicted by the evidence. The second makes it somewhat clear.
In an essay written in Fortune magazine published December 10, 2001, Warren Buffett laid out his thoughts on stock prices, the economy and interest rates. (Buffett W. , 2001).
Buffett wrote: “In economics, interest rates act as gravity behaves in the physical world. At all times, in all markets, in all parts of the world, the tiniest change in rates changes the value of every financial asset. You see that clearly with the fluctuating prices of bonds. But the rule applies as well to farmland, oil reserves, stocks, and every other financial asset. And the effects can be huge on values. If interest rates are, say, 13%, the present value of a dollar that you’re going to receive in the future from an investment is not nearly as high as the present value of a dollar if rates are 4%.” (Buffett W. , 2001)
This quote makes clear that rising long-term rates raise discount rates. Higher discount rates depress the intrinsic value or fair value of stocks. So, shouldn’t that make stock prices go down?
But, the last three and a half years has seen rising long term rates and higher stock prices. Something seems wrong.
In the same Fortune magazine article Buffett explains what, in his view, makes the stock market tick.
He compares two 17-year periods in the stock market. From December 31, 1964 to December 31, 1981, the Dow Jones Industrial Average moved from 874.12 to 875.00, i.e. barely at all. During that period the U.S. gross national product gained 373%! This apparent divergence is bizarre at first blush. Then, from December 31, 1981 to December 31, 1998, the Dow Jones Industrial Average went from 875 to 9181.43, i.e. a huge advance. During this period, the U.S. gross national product gained only 177%! Again, this is an apparently bizarre outcome. Investors might reasonably ask, what gives?
Buffett writes: “I concluded that the market’s contrasting moves were caused by extraordinary changes in two critical economic variables – and by a related psychological force that eventually came into play.” Buffett describes the two variables as, firstly, interest rates and, secondly, investor expectations for business profits. The psychological force is investor confidence.
Of course, he’s talking about two different things: stock prices and stock values. Just above he’s talking about stock prices. Earlier he was talking about stock values.
What it all means
It is hard to say, with all benefit of hindsight looking back on decade after decade of economic and stock market cycles, that the stock market (prices), interest rates and the economy were marching in lockstep or, in some actionable way, were correlated. It is true that companies need a properly working economy to make money. They don’t need boom times. And, many companies make money even in recessions. From time to time, one reads mathematical analyses of business cycles, interest rates and stock market cycles attempting to make some generalizations.
Generalizations from a handful of cycles prove nothing. It is the law of small numbers. Humans love to make generalizations from small samples.
Often, even good sized samples show you can’t generalize.
This from Professor Robert Shiller: “Over the whole period [1880 to 2005], there was not a strong relation between interest rates and the price-earnings ratio. In the Great Depression, interest rates were unusually low, which, by the Fed Model, would imply that the stock market should have been very high relative to earnings. That was not the case. Interest rates continued to decrease after the peak in the market after 2000, and then we saw the opposite of the predictions of the Fed Model: both the price-earnings ratio and the interest rates were declining. Since this happened, one has heard a lot less about the Fed Model. Although interest rates must have some effect on the market, the behavior of the stock market is not just a predictable reaction to interest rates. There is a lot more going on in the stock market, and a lot more for us to try to understand about its behavior.” (Shiller, Irrational Exuberance. 2005 Second Edition) p.9. (Emphasis Added)
Interest rates both short term and long term do impact on the economy. Stock values are more impacted by long term rates than short term rates. Stock prices can react to interest rate rises and lowered rates.
One thing is very clear. Trying to determine the outlook for interest rates and the economy is not a sound basis for making investment decisions. It is remarkable how many stock market commentators focus on interest rates and the state of the economy and the prospects for the economy in the next six months to a year in providing advice about investing and asset allocation.
Conclusion
If you had a crystal ball about the direction of long term over the next three years, you would be none the wiser. The direction of long-term interest rates over the last three years was up. But, over that period, stocks did not go down. So, if you knew the direction of long-term rates was going to be down, it wouldn’t necessarily mean stocks would be up. And vice versa.
In the short to medium term the outlook for interest rates and the economy and the stock market is always uncertain. Such forecasts are a frail basis for investing. As John Templeton says in his Maxim 14: “Too many investors focus on ‘outlook’ and ‘trend’. Therefore, more profit is made by focusing on value.” Or as Warren Buffett put it above, his investment decisions “reflect an opinion about long-term business prospects for specific companies.”
As time goes by
I’m now into the sixth year of writing this blog. In 2019, a well-known New York money manager and successful author suggested to me that I put down my thoughts on investing in a blog. Since I started the blog in July 2019 my web site has been visited by investors from over 150 countries around the world; yes, that’s one hundred and fifty countries! I am eternally grateful for the advice I got. By articulating my investing thoughts in a series of posts I have clarified and improved my own investment thinking. And hopefully my readers have also improved their own approach to investment.
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I’m also on Twitter @rodneylksmith
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