Are Low Rates Justification For High Stock Prices?

Discounting cash flows to estimate stock values far into the future should incorporate a factor for the risk of an error of the estimates, which may increase geometrically every 15 or so years. This means that even if interest rates are low the discount rate can be higher, the further out in the future one goes, because of an increase in risk premium. This means that the present era of the next 10 or 15 years is much more important to establishing the Discounted Cash Flow of an investment because the distant future has to be discounted so heavily that its returns regardless of outcome have less weight.
Thus if interest rates remain very low for 10 to 15 years and then normalize that means that the low rates of the next ten or 15 years are what should count rather than higher rates far in the future. This means that the tradeoff between stocks versus bonds, where stock bulls claim that low bond yields justify high stock prices, may have some validity to it. However, the riskier the economy becomes, the more that people may act like the phenomenon of Treasury bond “crowding-in” (bidding up bond prices and lowering yields in a flight to safety), lowering bond yields and thus propping up stocks because of the perceived relative value trade off.
But this is wrong since it is not rational for stocks to go up as a result of growing economic weakness that makes bond yields drop. The discounting mechanism not only counts the “raw” cost of capital such as Treasury rates, it also applies a hypothetical risk premium for various factors such as pollical instability, risk of recession, risk of inflation, risk of foreign government confiscation or devaluation, risk of tax increases, risk of trade wars, risk of increasing competition, obsolescence, etc. The worse things get the greater the discount rate becomes, even though as the economy worsens the risk free reference rate of Treasuries goes down due to the “crowding-in” phenomenon. Thus it may be possible that a universal discount rate exists in terms of a tradeoff where improving economic conditions act to raise interest rates while at the same time reduce risk and thus lower a component of the discount rate, which in some cases could be an even trade off so that no change occurs in the composite discount rate.
Thus I wouldn’t put faith in the idea that low interest rates make the discount rate go down (which would increase asset values). Instead low interest rates could be like the “Value Trap” where a declining stock price increases the yield of a company that maintains constant dividend but the decline is caused by an impending corporate failure and the result is investors get lured into buying a low priced stock only to find it was low priced for a reason.  This tradeoff reminds me of the old Modigliani-Miller theorem that it doesn’t matter how much percent of a corporation’s capital assets are financed by either debt or equity capital because various benefits and detriments from combinations of debt and equity act to offset each other.
It seems clear that the current era of low interest rates is in response to very low GDP growth and high hidden unemployment as well as the massive global Savings Glut mainly coming from China and EM countries. A Savings Glut means that those owners of wealth can’t find any good projects to invest in inside of their home country so they are willing to park funds in a low yielding G7 sovereign bond. This implies that expected returns from investing in China are negative. If China is the driving engine of the world’s growth then why are its citizens trying to get their wealth out of their country? Do they have insider information that business ventures in China have negative returns? If so then that implies the global economy is at contingent risk of a slowdown, in which a high discount rate for stocks is appropriate. This implies that stocks’ values are lower than what is perceived by most people.
Investors need independent financial advice about the risks of being fooled by low bond yields into thinking that stock market discount rates should also be low and that therefor stocks should have high values. Instead discount rates should be reinterpreted as higher than perceived and thus stocks should be reduced in value.

2017-04-05T15:18:40-07:00 April 5th, 2017|mayflowercapital blog|Comments Off on Are Low Rates Justification For High Stock Prices?

About the Author:

mm
Donald Martin has a B.A. in Accounting and M.B.A. Finance, and has passed the rigorous CFP® exam and met the experience requirements needed to become a CERTIFIED FINANCIAL PLANNER™ professional. He has been employed in the financial services industries for 30 years and has been investing for his own account for 38 years. Donald Martin’s 19 year career in lending prepared him for fixed income analysis, Securities analysis, and macro-economic analysis used for investing. Donald Martin founded Mayflower Capital in 1993 to provide independent financial advice and implementation of advice about loans. In 2005 Donald Martin changed the company’s mission to providing independent financial advice about investments and financial planning and stopped providing loan services. Donald Martin has a B.A. in Accounting and M.B.A. Finance, and has passed the rigorous CFP® exam and met the experience requirements needed to become a CERTIFIED FINANCIAL PLANNER™ professional. He has been employed in the financial services industries for 30 years and has been investing for his own account for 38 years.