It seems like everyone is talking about what the Fed is going to do with interest rates nowadays. Some people think rising interest rates will cause the stock market and housing market to crash, while others think growth in the economy will balance out the effects of rising rates. But why is it that interest rates play such an important role in the value of assets? Let’s take a look at one of the reasons — the equity risk premium.
Equity risk premium
The equity risk premium is the extra potential return that is required from an investment in stocks relative to an investment in something considered safe. Many investors use the United States Treasury bond as a measure of a safe investment. The yield on the bond is used as the risk free rate because it is unlikely that the government will be unable to pay its debts. Since stocks are considered more risky than bonds backed by the government, stocks need to offer a higher return than the bonds. After all, why would someone buy a stock that is expected to return 5% a year if there is a government bond that offers 6%? An investor might require an expected 10% return from stocks to choose stocks over bonds in this case. The difference between the 10% from stocks and the 6% from bonds is the equity risk premium. In this example, the equity risk premium is 4%.
If we assume that the equity risk premium remains the same, a rise in interest rates will require a higher rate of return from stocks, otherwise an investment in stocks won’t be worth it considering the risks involved. The businesses can either perform better and increase their earnings so that the stocks are still attractive compared to bonds or the stock prices will need to decrease to a more attractive valuation.
Change in stock price
To see why a decrease in stock price makes an investment more attractive, take a look at the inverse of the popular P/E ratio. The earnings per share / price per share of a stock gives you an earnings yield on the stock. If a $20 stock with $1 in earnings drops to $15, the earnings yield just increased from 5% to 6.67%. This is why the price an investor pays for a stock is so important for future returns.
Although changes in interest rates have an impact on the required rate of return for other assets such as stocks, there are many other factors involved. The relationship between interest rates and stock returns isn’t perfect. For example, interest rates are usually raised when the economy is doing well and the government wants to slow down the heated economy to prevent rampant inflation. The better economy might increase earnings for businesses so that the stocks won’t have to decrease in price.
Impact of interest rates
Take a look at this chart of the 10 year Treasury compared to the S&P 500 with historic data from Professor Robert Shiller.
As you can see from the graph, the stock market has advanced in the more recent years as interest rates declined, but if we look at the earlier years, changes to interest rates barely seem to matter as stocks compound over time. This isn’t to say that it was a smooth ride. If we take a look at the percentage change for the 10Y Treasury and S&P 500 by year, we see that there was a lot more change than meets the eye in stock prices.
Interest rates play a role in stock prices, but they are not the only factor. They are also impossible to predict even though the Fed gives hints about their future actions to prevent sudden shocks to the market. Most investors who buy an index fund that tracks the S&P 500 should do well with a consistent strategy that systematically invests more money at regular intervals. They should forget about interest rates and use dollar cost averaging to their advantage. This way, it won’t matter if an investor buys when interest rates are high or low because over time, the price paid for the stocks will balance out and the investor will achieve a fair return. They can get the results of the first chart instead of worrying about the second graph.