Valuations, Stock Returns & Interest Rates. — June 10, 2017
Before I begin, I thought I’d include a longish quote from The Oracle, to lend perspective –
“Let’s start by defining ‘investing.’ The definition is simple but often forgotten: Investing is laying out money now to get more money back in the future – more money in real terms after taking inflation into account.
“Now, to get some historical perspective, let’s look back at the 34 years – to observe what happened in the stock market. Take, to begin with, the first 17 years of the period, from the end of 1964 through 1981. Here’s what took place in that interval:
- DOW JONES INDUSTRIAL AVERAGE Dec. 31, 1964: 874.12, Dec. 31, 1981: 875.00.
“Now I’m known as a long-term investor and a patient guy, but that is not my idea of a big move.
“To understand why that happened, we need first to look at one of the two important variables that affect investment results: interest rates. These act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull. That’s because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So, if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates in line.
“The increase in equity values since 1981 beats anything you can find in history.” – Warren Buffett in 1999
It sure seems there is a lot of investing wisdom in that quote, right?
Inflation/Interest rates generally headed higher between 1964 and 1981 before Paul Volker, Chairman of the Federal Reserve, started to drop the hammer on inflation in October 1979 and doubled the Fed Funds rate over the next 4 months. In the 2 years following, inflation rates fell from over 14% to under 5%, and the Fed Funds rate fell from 19% to under 9%, setting up the greatest and most enduring bull run in history.
For clarity, Blue is the effective Fed Funds rate, red is inflation, green is the stock market in the form of the Wilshire 5000. The impact of lowered interest rates is pretty clear.
Nice to know, but what can that do for me today?
Here’s a more recent Buffett quote – “Measured against interest rates, stocks are actually on the cheap side compared to historic valuations. But the risk always is interest rates go up, and that brings stocks down.”
How? You might be asking. We’ll get to that in a minute. But first, was Buffett just blowing smoke? After all, words are one thing, action another.
Buffett spent around $18 billion on Apple stock in the last year and a half. That’s a reasonable bet on where he sees interest rates going, at least in the next few years.
I happen to agree. As I’ve said several times, my view is lower rates for longer. For interest rates to approach historical averages (Y Charts says that’s 6.1% on the 10-year Treasury) the economy must strengthen. A lot.
In my view, GDP growth would basically need to double. I just don’t see any way that can happen in the near term. So, lower for longer. My best guess right now is 5 years (or more) below a 3.5% Federal Funds rate, and about the same before we see a 10-year Treasury above 5%.
So, are stocks overvalued? Some of them, yes. Some not. But interest rates are just above historical lows, and that’s supportive of the stock market.
Exactly how do lower interest rates have such an impact on stock valuations?
There are many formulas and concepts available to understand the value of a stock and the impact of interest rates, but as we are looking at things through the lens of Buffett’s tremendous investing brain, let’s use one of the concepts near and dear to his heart – the quick and dirty intrinsic value formula of his chief mentor, Ben Graham.
V = EPS x (8.5 +2g) x 4.4 / Y
V = Intrinsic Value
EPS = the company’s most recent 12 month earnings per share
8.5 = the appropriate PE ratio of a company that expects 0 growth
g = the long term (five years) growth estimate
4.4 = the average of high grade corporate bonds in his era (3.6% in our era)
Y = the current yield on 20-year AAA corporate bonds (we’re going to use 10 year Treasuries at 2.2%)
Let’s have a look at Apple with current interest rates in play, speculating they will endure for at least a few years more.
Apple EPS = $8.57
Apple consensus 5-year earnings growth (“g”) = 10.12%
3.6% average yield high grade corporate bonds
2.2% 10-year Treasury yield
V = 8.57 x (8.5 + 2(10.12)) x 3.6 / 2.2
= $403.04 projected intrinsic value.
The notion here is that at some point, ideally in about 5 years, Apple’s price will reflect its intrinsic value. There is no doubt in my mind this number was part of Buffett’s process in deciding to buy Apple. However, it was assuredly NOT the only part.
Even Graham said that this simplified formula shouldn’t be used as the only criteria to decide to invest/not invest, but it is an informative tool to show what can happen to stocks when interest rates rise (or fall).
Now, let’s have a look at see what impact rising interest rates might have on Apple’s intrinsic value. Let’s use the 6.1% historical 10-year rate from Y Charts. Let’s pretend investment grade corporate bonds are yielding 1.4% more than Treasuries, just as today.
Apple EPS = $8.57
Apple consensus 5-year earnings growth (“g”) = 10.12%
7.5% average yield high grade corporate bonds
6.1% 10-year Treasury yield
V = 8.57 x (8.5 +2(10.12)) x 7.5 / 6.1
= $302.83 projected intrinsic value, a value reduction of 25%!
It’s clear interest rates can have a tremendous impact on stock value.
It’s also clear why Buffett was comfortable spending $18 billion on Apple stock at around $100 per share.
Lastly, it’s an unambiguous statement about his expectations for interest rates, at least for the next several years.
Will he be right? I certainly hope so. I’ve been on the same page as Buffett a couple times (Precision Cast Parts and Apple) and it would be great if we were both right here, too.
In sum, with interest rates very low on a relative basis, growing earnings, and no recession currently on the horizon the market can be expected to move higher over the intermediate term (2 – 5 years) – which probably means investors will get more money back in the future in return for dollars invested today.
That doesn’t mean the market is going up tomorrow – I’m about as good at predicting where the market will be 6 months or a year from now as Buffett, which means marginal to no good (barring recession). But current conditions still favor stocks over bonds. That is likely to continue until conditions change.
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ACI Wealth Advisors, LLC.
Process Portfolios, LLC.
This is an illustration and is not a recommendation to buy Apple. Price paid has an impact on expected returns, and the Graham Formula is just one of many ways to evaluate a stock investment. ACI uses nearly 2 dozen investment/financial models and several modes of research to identify and evaluate stocks for the Durable Opportunities Portfolio. Disclosure: ACI owns Apple in the Durable Opportunities Portfolio.