Interest Rates and Stock Prices

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There has been a lot of concern about rising interest rates the past few weeks due to the government showdown over raising the debt ceiling. Fear mongers reported that failure to raise the debt ceiling would lead to a default by the U.S. on its debt. A U.S. default could lead to higher interest rates.

On the other hand, Federal Reserve Chairman Ben Bernanke implied that more monetary stimulus may be needed to get the economy growing at a pace that will reduce unemployment. The Fed has been keeping interest rates at historic low levels for some time already. Monetary stimulus would provide additional pressure to keep interest rates low.

The debt ceiling situation may raise interest rates while more Fed stimulus would keep interest rates low. What does all this mean for stock prices?

The Fed has room to keep interest rates low as long as inflation is under control. Currently the expectation is for low inflation when we measure the outlook for inflation by the 10-year Treasury note yield, currently in the 3.2% range.

And, when these rates are put together with the S&P 500 Index stock earnings projections for next year, bulls may be encouraged. The role interest rates play in stock valuations cannot be overemphasized. Valuation models are built on a foundation of a risk-free rate of return, commonly using the 10-year Treasury as that part of the model. In general, stocks are worth more as interest rates fall and earnings rise.

Among the more common ways of valuing the overall stock market is the so called “Fed model,” which relates the earnings yield on the S&P 500 to the yield on the 10-year Treasury bond, where the earnings yield on the S&P 500 is calculated as the predicted future earning of S&P 500 firms divided by the current value of the S&P 500 Index.

To illustrate how this works, consensus earnings estimates at the end of June 2011 for the next 12 months was $106[i] and the S&P 500 closed at 1321, producing a yield of 8%. The 10-year Treasury yield was 3.2%. Since the model calls for the two yields to be in equilibrium, the S&P should be priced around 3300. This rough model illustrates how extremely undervalued stocks are based on historical methods of valuation. Note that this model does not factor in event and other unusual risks associated with investing.

[i] Source: J.P. Morgan Asset Management. Forward Earnings is by consensus analyst estimates of earnings per share for the next twelve months. Data are as of 6/30/11.

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