Q & A: How will low interest rates impact the stock market?
By: Stacey Nickens
Last week, the Fed announced that they will likely keep interest rates near zero through 2023. Doing so helps weaken the American dollar and thus increase U.S. exports. (U.S. goods become cheaper than foreign goods, inspiring export activity and foreign investment.)
Theoretically, lower interest rates lead to higher stock valuations. The increase in stock valuation would occur alongside the reduction in bond valuation. As interest rates decline, bonds offer lower coupon rates, and investors are more likely to see stocks as a preferable option. Lower interest rates should thus increase a stock’s price-to-earnings (P/E) ratio as investors are willing to pay more for each dollar the company earns.
In reality, interest rates and a stock’s P/E ratio do not necessarily have a linear relationship. For example, let’s consider General Dynamics’s stock. Between 2000 and 2008, interest rates dropped as did General Dynamics’s P/E ratio. Between 2011 to 2018, interest rates moved opposite GD’s P/E ratio (as the above theory suggests would happen), and after 2018, both interest rates and GD’s P/E ratio have been dropping.
The unpredictable relationship between interest rates and a stock’s P/E ratio suggests that interest rates don’t necessarily meaningfully impact a stock’s value, at least not in a predictable way. Rather, a company’s stock almost always reverts to performing in accordance with a company’s intrinsic value. Far more important than investor sentiment, a company’s intrinsic value (as measured by their earnings and cash flow) largely determines a stock’s long-term success.
Knowing that, interest rates are thus only meaningful for stock valuation long-term if they impact a company’s intrinsic value. Such could certainly occur, depending on how much debt the company is holding and other factors. For example, if a company can borrow cheaply because of low interest rates, that may increase their future cash flow.
Altogether, though, lower interest rates do not inherently justify increasing stock valuations. Instead, rising stock valuations should only be trusted if they track alongside commensurate company value.