Investor Handbook: Why Lower Interest Rates Are Good for Stocks

Source: Thinkstock

Source: Thinkstock

Investors often mistakenly believe that bonds and stocks trade inversely to one another. Bonds, particularly Treasury Bonds, have been called “safe haven” assets, and we have seen recently that when stock prices have weakened, Treasury Bond prices have strengthened. But this short-term negative correlation is misleading. Bonds and stocks often trade together in the longer term. For instance, both stocks and bonds were in a bear market in the 1970s and they entered a bull market in the early 1980s simultaneously.

There are good reasons that investors should expect a correlation between bonds and stocks. For starters, investors value stocks based on the return that they can get by owning them. This return is often measured by a company’s earnings, and a stock is valued based on its price relative to these earnings. If bond prices rise and interest rates fall then investors, who are getting a lower return in the bond market, will come to accept lower returns in the stock market. Similarly, if bond prices fall, stocks become less enticing as investors can get similar returns in bonds without the risk that comes with stock ownership (e.g. earnings fluctuation.)

Second, in a low interest rate environment not only are stocks inherently worth more in relation to bonds, but companies are more valuable insofar as they can borrow money at a lower rate. When bond prices rise and interest rates fall this usually takes place across the entire bond market. Thus, companies who can access the debt markets can borrow at a lower rate when bond prices are low. This gives these companies more money with which to invest.

Furthermore, combining these first two points, when interest rates are low companies can borrow money at a lower rate in order to buy stocks that now appear to be less expensive in relation to the borrowing rate. This leads to mergers and acquisitions. For instance, we saw recently that Tyson Foods (NYSE:TSN) bought Hillshire Brands (NYSE:HSH) in part because it could borrow the money to do so. Tyson is going to increase its earnings because the amount of additional earnings it can generate with Hillshire Brands’ brands exceeds the interest it needs to pay in order to finance the deal. In a high interest rate environment this deal wouldn’t have made sense, and more likely than not, Tyson wouldn’t have been able to find the necessary funding that it would need to carry it out.

It follows that in a low interest rate environment it makes sense for companies to borrow money in order to buy back stock. After all, if a company can borrow money at 3 percent in order to buy back your own stock which trades at 20-times earnings (or at a 5 percent earnings yield) it is as if you are pocketing the spread. But as the company does this, the number of shares outstanding declines and so the earnings increase on a per-share basis, and this means that the trade makes even more sense. We have seen some very strong performances from companies who have taken this principle to its natural conclusion, like AutoZone (NYSE:AZO) and Lorillard (NYSE:LO).

Given these points, stocks don’t look so expensive right now with the S&P 500 trading at about 22-times earnings. But at the same time, this idea that we will see a rotation out of bonds and into stocks doesn’t make sense — the current valuation of the S&P 500 requires that interest rates remain low. This means that as vulnerable as bonds are to steep declines, stocks are just as vulnerable. If bond prices were to decline to reflect historic norms then current valuations would make no sense, and companies who have been borrowing money in order to make deals and to buy back their own shares would have to stop doing this.

Disclosure: Ben Kramer-Miller has no position in the stocks mentioned in this article.

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