Interest Rates and Their Impact On Stock Values


Many investors are attempting to justify higher stock “valuations” because interest rates are at historical lows. I would agree that lower interest rates could affect “market valuations” based on the simple law of supply and demand. The concept is simple, when fixed income offers lower returns it logically stimulates more demand for equities where higher returns can be found. In contrast, when fixed income provides high yields, it reduces the demand for equities because they in fact become less competitive. However, that is market value which functions in an auction market – again, under the rules of supply and demand.

However, lower interest rates have not in recent times caused P/E ratios (common stock valuations) to rise. In my experience, there will be an inverse relationship between interest rates and stock valuations (P/E ratios) when stocks are being valued properly by the market. However, in the real world, there are many other factors that I believe are significantly more important than the level of interest rates, which are an exogenous force. In other words, forces that are internally part and parcel of the underlying business are more relevant to valuation than outside forces like interest rates.

To be clear, by internal forces I am referring to the actual operating results and success of the business itself. In the long run, the company’s ability to generate earnings and cash flows will be the predominant determined of future returns and valuation at any point in time. Good fast-growing businesses are worth more than poor slow-growing businesses.

Nevertheless, the key part of the above thesis is the phrase – in the long run. This is simply because markets can be dominated by investor sentiment (fear or greed) in the short run. However, business results (fundamentals) will inevitably reign supreme. This is why I always say that I trust fundamentals more than I trust short-term price movements.