Interest Rates

Quiz!

Are Extended-Term Component (ET) valuations lower or higher when interest rates are higher?

1. Lower
2. Higher

Dispelling a Myth: Stock Valuations are Always Lower with Higher Interest Rates

When interest rates are higher, there are 2 implications for stock valuations (Price/Book):

1. Negative: Future earnings get discounted more, justifying lower stock valuations – what people expect. This effect is smaller for value stocks that are valued more based on near-term earnings.
2. Positive: The reason for higher interest rates tends to be higher inflation, which represents higher prices charged by companies. Higher income to the companies justifies higher valuations.

Extended-Term Component (ET), a portfolio that emphasizes deep value stocks, is impacted more by the positive effect. The chart below shows a positive relationship between the Fed Rate and valuations (P/B) for ET, since 1999. With today’s rates at 5.25%, the range of valuations is raised, making current valuations (P/B = 0.87) close to the low end of the range (of: 0.73 to 2.08). If history repeats itself, it could point to more upside potential.

Adding to the good prospects, the Fed’s preferred measure of inflation is holding steady for a 5^th month, with a slight increase last month to 4.7%. This is more than double the Fed’s target of 2%, adding pressure on the Fed to keep raising rates. With headline inflation peaking at 9.1% last year, and historically interest rates rising above peak inflation, it is possible for interest rates to peak above 9.1%, which is about 4% higher than today. If interest rates peak higher than today, valuations may also peak higher, adding to the positive forces.

Notes: Future ranges can be different, and there is no guarantee that future interest rates will be higher. Small note: the 6% rate column (the last one) is impacted by limited data.

Quiz Answer:

Are Extended-Term Component (ET) valuations lower or higher when interest rates are higher?

1. Lower
2. Higher [Correct Answer]

Explanation: See chart and explanation in this month’s article.