Sandwich Ma-se Market Topic Lecture | Part 8. The Relationship between Interest Rates and Stock Prices
Sandwich Masae introduces topics that are of interest in the current market. This time, about “the relationship between interest rates and stock prices.” He will clearly explain the relationship between two important indicators that many investors are watching in the market. Note: The content of this article reflects the author's views and does not guarantee future profits.
Link to the previous article
→Sandwich Masae's Market Topic Course | Part 7. Inflation
As of August 2021, even as concerns grow about a renewed spread of the coronavirus due to the Delta variant, US stocks continue to rise. Behind this rise in US stocks, interest rates have also been rising.
This time, let's整理 the relationship between interest rates and stock prices.
1. Inflation and Interest Rates
In fact, as of August 2021, long-term US interest rates had fallen from their peak. In the author's view, market participants interpret the inflation in the United States as temporary, so even at high inflation levels, many investors move to buy bonds. Therefore, I think rates may be on a downward trend.
However, it is certain that the Federal Reserve is moving toward tapering and rate hikes, so medium- to long-term interest rates are expected to rise.
2. The Relationship Between Interest Rates and Stock Prices
Now, the theme of this column is the relationship between interest rates and stock prices. Here, the interest rate referred to is the long-term rate, but what kind of relationship exists between stock prices and interest rates?
When discussing the relationship between interest rates and stock prices, the “theoretical stock price” formula is often cited.
A representative one is the Dividend Discount Model (DDM).
Theoretical Stock Price = Dividends / (Interest Rate + Risk Premium - Growth in Earnings)
This dividend discount model derives the theoretical stock price from the idea that the theoretical price is the present value of the cash flows investors will receive in the future. I'll pass the detailed explanation to others, but from this formula you can see that the denominator includes the interest rate.
Simply put, if interest rates rise, the theoretical stock price would fall. In other words, the theory that rising rates lead to falling stock prices seems to apply.
However, when you整理 the situation where “rates rise,” you may realize that this theory may not always hold.
First, there is the distinction between nominal interest rates, which do not deduct inflation, and real interest rates, which do deduct inflation. The formulas are as follows:
Nominal Interest Rate = Real Interest Rate + Inflation Rate
Real Interest Rate = Nominal Interest Rate - Inflation Rate
The interest rates we commonly see, and the rates used in the theoretical stock price formula, are nominal interest rates. As the above formula shows, if real interest rates do not change, a rise in inflation pushes nominal rates up.
That is,Inflation and interest rates have an inseparable relationshipas we can see.
Turning to the denominator in the theoretical stock price formula, let's also look at earnings growth. When inflation progresses, nominal earnings growth can be expected to rise.
Example
＜If Inflation Rate 0% and Real Earnings Growth 10%＞
Previous period earnings: 100,000 thousand yen
Real earnings growth: 10.0%
Inflation rate: 0%
Current period earnings: 110,000 thousand yen
Nominal earnings growth: 10.0%
＜If Inflation Rate 2% and Real Earnings Growth 10%＞
Previous period earnings: 100,000 thousand yen
Real earnings growth: 10.0%
Inflation rate: 2.0%
Current period earnings: 112,200 thousand yen
Nominal earnings growth: 12.2%
Nominal earnings growth is the company’s intrinsic real earnings growth plus the impact of currency depreciation = inflation.
Let's look again at the theoretical stock price formula.
Theoretical Stock Price = Dividends / (Interest Rate + Risk Premium - Growth in Earnings)
As explained so far, in a scenario where inflation progresses and nominal earnings growth also rises with rising rates, the theoretical stock price does not change when plugged into the formula. In other words,the relationship between interest rates and stock prices can be considered neutral.
As can be seen from recent trends in US stock indices, stock prices continued to rise even when rates were rising.
The textbook investment rule of “rising rates = falling stocks” is sometimes discussed as a short-term factor for stock weakness, but a high interest-rate environment can also be interpreted as indicating the economy is doing well, i.e., earnings growth is rising. From this perspective, the idea that “rising rates lead to falling stocks” may not be a firm rule to be stated as an absolute.
In the future, market themes may focus on “rates.” However, investors should continue to pay attention to the fundamental value of stocks, i.e., corporate performance.
※The content of this article is based on the author’s views and does not provide definitive investment judgments. It is for information purposes only and does not solicit the purchase or sale of any type of product.
A first-class Financial Planning Skillful Professional. Worked in the banking sector in financial product sales, then joined Invast Securities as a currency dealer. Currently in the Marketing Department, engaging in activities to spread the enjoyment of investing to the world. Known locally as someone who answers financial questions instantly, and strives daily to be a trusted figure for others. Also a Sandwich enthusiast to the point that colleagues say, “You never seem bored…” Always handles work with a sandwich in hand. Additionally, every night before bed, makes the sandwich for the next day, a domestic side that some may find charmingly romantic.
