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Author: andrewychan Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 5655  
Subject: Interest Rate and Market Performance Date: 3/23/2002 8:34 PM
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Hello fellow Boring investors,

At the demand of TheStamper, I will try to contribute a little more on valuation on the Boring board. Here is a post that I originally wrote on the NPI board, but it doesn't seem to be drawing passion from anybody. I think that this could be of interest to you. Sorry if this may sound a little unsophisticated from a valuation standpoint. Many of you are already familiar with valuation model and quite sophisticated about it, so my post may only repeat what you already know. Keep in mind that this was written for the NPI board, which talks much less about valuation than the Boring board.

I think that many of you have already read the Fortune article on Warren Buffett which was published in December 2001. http://www.fortune.com/indext.jhtml?channel=print_article.jhtml&doc_id=205324

I was greatly inspired by this article, as it dealt with the effect of changing interest rates on market performance, and digged into history myself and try to see it from a valuation multiple perspective. So last week, I went to McGill University's library and look through the archives of the S&P Outlook magazine from Jan. 1990 to May 1991. This, if you remember, coincide with the last recession (and last war).

It gives a great perspective looking back at today's economic conjunction. Back in 1991, I was too young to look at the stock market, so I needed to look through these archives. This is also a reason why I trust Warren Buffett's judgment in terms of stock market perspective as he has much more experience than I do. I don't blindly believe all he says, but I judge what he says and I can make my own opinion about it.

Anyway, here are my findings. Historically (excl. 2001, I don't have the data, probably somewhere around 25x), the AVG bottom P/E ratio when the economy was in a recession has been 9.6x. The average P/E entering a recession was 11.6x. Today, the forward P/E for the S&P 500 is somewhere around 27-28x.

Looking back at 1990-91, the P/E ratio ~11.6x in 1990 and 13x entering the recession.

Why were multiples so low? Answer: Interest rates... and that's pretty much it. If you ever have the chance to plot historical L-T Treasury Bond yield against the market P/E, it will give you extraordinary insights in understanding valuation. Anybody who has “played” with a DCF model knows that the discount rate (which is a function of the risk free rate) is the most sensitive factor in a DCF model. Hence the importance of interest rates.

The last time nominal interest rates were comparable to today's was in 1964: 4.20%. Back in 1990, interest rates were around 10%. Interest rates started going down in August 1990 as talks of recession were starting and the Gulf War was looming.

Since then, we've barely looked back and interest rates decreased by more than 50% since 1990.

Looking at charts that compare interest rates and P/Es, it's quite easy to see the negative correlation. Back in 1964, when interest rates were at 4.20%, P/Es reached at high of 24x. In 1990, rates were at 10% and the P/E was ~11x...

From 1991 to 2000 (10 years), the S&P 500 has performed at an annual rate of 17.5%, significantly higher than the historical 11% return. Why? It's not so much about corporate profit than it is about interest rate. Long-term Treasury bond yields were slashed in half over that period, which warranted a huge multiple expansion, from 11x to 30x.

Therefore, much of the stock performance over that period was due to declining interest rates as much (if not more) as it was about growth in profits. As interest rates decreased and growth increased, you had two forces acting together to push stock prices up. Multiple expansion alone accounted for more than 55% of your gains from 1991 to 2000. The market over that time was a five bagger, multiples nearly tripled. If corporate profit had not grown, the market would have almost tripled simply due to multiple expansion, which was triggered in large part by interest rate decline.

What's the point of this story? Well, let's look forward. A lot of people are still expecting the same kind of return we've had in the 1990's. If people acknowledge that interest rates played a big part in the performance of the 1990's, it's hard to support this kind of expectation going forward. While I am not saying that interest rates will increase in the next 2 or 3 years (I don't know), it's nevertheless hard to justify that multiples should further expand. The Fed has decreased the fed fund rate to 1.75%, yet over that time, the LT T-Bond yield (10-year) increased slightly…

The low interest rate environment may warrant a high multiple market. But looking into the future, it means that we won't benefit from multiple expansion since LT yield don't have much room on the way down, at least not as much as it did starting in 1990. The most optimistic scenario would be that LT interest rates decrease by 100 basis points, nothing compared to the 500 basis point decline since 1990. The lesser optimistic scenario is that rates rise again.

High multiples may be justified, but it won't help us in getting the same kind of return as we had in the 90's.

Now, I haven't talked about corporate profits. It's about stock valuation and interest rates. I may sound bearish about stocks, but I am far from bearish about the economy.

Here is the link to Fortune's article on Buffett again: http://www.fortune.com/indext.jhtml?channel=print_article.jhtml&doc_id=205324

Buffett does a much better job at explaining how interest rates affect stock market performances than me.

Here's an excerpt:

Here I need to remind you about the definition of "investing," which though simple is often forgotten. Investing is laying out money today to receive more money tomorrow.

That gets to the first of the economic variables that affected stock prices in the two periods--interest rates. In economics, interest rates act as gravity behaves in the physical world. At all times, in all markets, in all parts of the world, the tiniest change in rates changes the value of every financial asset. You see that clearly with the fluctuating prices of bonds. But the rule applies as well to farmland, oil reserves, stocks, and every other financial asset. And the effects can be huge on values. If interest rates are, say, 13%, the present value of a dollar that you're going to receive in the future from an investment is not nearly as high as the present value of a dollar if rates are 4%.


Fool on!

Andrew
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