The idea that interest rates directly affect stock prices is a commonly held belief among many investors. There are some that even go as far as to say that the only reason the stock market is up is because interest rates have been artificially kept low by the Fed. With this article, I’m going to apply some commonsense logic to interest rates and their true impact on stock values.
There are many generalities spouted regarding how interest rates affect stock prices. For example, many argue that there is an inverse relationship between interest rates and stock valuations. The argument suggests that when interest rates are high, fixed income investments such as bonds are more competitive and therefore this diminishes stock values. Conversely, when interest rates are low, fixed income is less competitive and therefore stock valuations will rise.
Although there is some validity in the above assertions, historical reality suggests that these relationships only work until they don’t. The reason this is true is because there are many factors that will affect the value of stocks with interest rates being only one.
Another commonly held belief about interest rates and stock values goes something like this: when interest rates go up, the discount rate will increase to reflect the increase in interest rates. Since stocks get their value by discounting future income streams to the present value, the higher discount rate reduces the value of those income streams. Therefore, the stock price will decline because the present value of that income stream is now lower. This theory is typically followed by the notion that when interest rates increase, multiples (P/E ratios, etc.) will decline, which also causes the stock to decline.
There are many variations to the themes presented above, however, they all pretty much ascribe to the theory that there is a direct inverse relationship between valuation and interest rates. Nevertheless, my experience suggests that these theories only work in a perfect market environment. However, the market is very rarely – if ever – perfectly aligned with economic theories.
Additionally, economic and/or investing theory can be applied either generally or specifically. By generally, I’m referring to the effects that things like interest rates would have on the overall stock market or stocks in general and on other macro factors such as inflation and GDP growth, etc. However, I personally tend to be more focused on specific or individual stocks on the theory that it’s a market of stocks not a stock market. In this regard, the effects of interest rates can be significantly different company by company.