Low Interest Rates May Not Affect Stocks the Way We Thought

[Jul 19, 2007.]

While there are plenty of reasons for those in the financial community to support low interest rates, now comes word that such rates may not have the effect on stocks that investors have come to believe.

Some analysts this July are saying that low interest rates are only good for the stock market when stock valuations are low. In fact, some financial experts believe that low interest rates are of no consequence in the case of rich stock valuations.

This is because low interest rates, on the basis of 10-year bond yields, are not enough to offset the adverse impact of rich stock valuations.

Here's how it works: when stock valuations are a cut above average and interest rates are low—say below 6% on the 10-year Treasury yield, market performance has been labeled as tepid, no matter what the trend in yields has been. In the minority of cases when there have been high valuations and low or declining interest rates, the S & P 500 has accomplished an average return of 6.22%. When there have been high valuations and low and rising interest rates, the total return has hit 5.41%. The returns are even more disappointing when valuations have been more than 18 times record earnings—the situation we now face.

The well-known Fed Model states that, when interest rates are high and stock valuations are low, the state of affairs can be considered neutral. However, some analysts now say that such a situation can actually be quite beneficial. This is because, when stocks are cheap and yields are high, there's an opportunity for yields to decrease and stock valuations to rise.

As a result of such analysis, investors in the stock market should not automatically draw the conclusion that lower interest rates are preferable. There's plenty of evidence to show that such is not necessarily the case.

Julie Ann Amos
July 19th 2007

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