Opinion: Raising interest rates scares the market, but stock investors focus on the wrong rate

The stock market has been spooked by rising interest rates. Let us reflect more carefully, from the point of view of value investing, on these concerns.

Warren Buffett famously argued that investors should think of stocks as “bonds in disguise,” where stocks pay dividends, similar to coupons that bonds pay, and can be valued similarly. Bonds are routinely valued by discounting their coupons and maturity value by their interest rate structure.

It would be wrong to use one rate of interest to value bonds with different maturities; For example, to use the same interest rate for the value of a three-month Treasury bond TMUBMUSD03M,
and 30-year treasury bonds TMUBMUSD30Y,
It would also be wrong to use one interest rate to value bonds at different coupon rates; For example, to use the same interest rate for the value of 20-year Treasurys TMUBMUSD20Y,
With coupon rates of 3% and 5%. Bonds should be valued using the full term structure, and informed investors do.

Exactly the same logic applies to stocks. John Burr Williams, one of the founders of Value Investing, wrote that “A continuous The rate is wrong, and it can only lead to wrong results.” In his classic treatise investment value theoryWilliams argued that the intrinsic value of the stock should be determined by discounting the dividend through an interest rate term structure (plus risk premium), which is similar to the term structure used to discount bonds. Dividends should be deducted three months from now at the rate of three months, and dividends for 10 years and therefore at the rate of 10 years.

Williams recommended that stock investors who want to use a single interest rate use a very long-term interest rate, specifically, the “forever yield” on Treasuries, the average term structure rates for bonds that never mature.

Williams’ arguments for the full term structure have not been recognized. Instead, academics and stock investors generally use a single interest rate, usually a short-term rate. For example, finance books by Copeland and Westin; Boddy, Ken, and Marcus; Both Body and Merton use the price of three-month Treasury bonds. Textbooks by Brilly, Myers, Ross, Westerfield and Jaff use one-year Treasury bonds TMUBMUSD01Y,
Both Bank of America Merrill Lynch and Goldman Sachs used 5-year Treasury bond rates. JPMorgan Treasury has used TMUBMUSD10Y for 10 years,

The use of a short-term rate is sometimes justified by the argument that investors intend to hold the shares for only a few months. This is like saying that investors who intend to sell 30-year Treasuries after three months must value the bond by discounting the 30-year coupons at the price of the three-month Treasuries. This argument is clearly wrong for bonds and it is wrong for stocks as well.

The intractable problem with using a single interest rate – short or long – is that valuations are unreasonably tortuous and tortuous as the term structure fluctuates and shifts. Between March 31, 2010 and June 30, 2010, for example, six-month and one-year Treasury rates were stable, while long-term rates fell by almost a full percentage point. Investors who use short-term rates will not change their valuations; Investors who use long-term rates may increase their valuations significantly.

Between December 31, 2007 and March 31, 2008, Treasury rates rose after 18 years while short-term interest rates collapsed. Investors using long-term rates may conclude that stock valuations have fallen, while investors using short-term rates will reach the opposite conclusion. Both can work better using the full term syntax.

Long-term rates have only increased modestly – and long-term rates are more important for stock valuation.

Long-term rates are usually higher than short-term rates to compensate investors for greater market value risk. The current sloping term structure beyond one-year rates indicates that bond investors expect interest rates to be lower in the future than they are today. They may be wrong, but current interest rates are what investors should consider when deciding whether to buy stocks.

The big jump in short-term rates is already astounding, but long-term rates have only increased modestly – and long-term rates are even more important for equity valuation. From June 1 through earlier this week, the S&P 500 SPX,
It’s down 11%, so the current dividend yield for the S&P 500 is about 1.75%, compared to the 30-year Treasury rate of 3.70%. If dividends grow about 2% per year, on average, for the next 20, 30 or 50 years, stocks will be the most financially rewarding investment.

More generally, investors should value stocks using a long-term interest rate structure. For those who insist on using a single interest rate, the best rate is a very long-term rate such as the forever return recommended by John Burr Williams – which, as far as I know, no one uses. The worst option is short-term prices – they are also the most common.

Gary Smith is the Fletcher Jones Professor of Economics at Pomona College. He is the author of a bookMoney Machine: The Surprising Power of Value Investing(Amacom 2017), author of a bookThe illusion of artificial intelligence,(Oxford, 2018), and co-author (with Jay Cordes) forThe nine pitfalls of data science(Oxford 2019).

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