I recently was reading Seeking Alpha when I stumbled upon on an article written by John Hussman. Hussman’s article, “Low Interest Rates Don’t Fuel Expensive Stocks,” piqued my interest because of all of the discussion and debate on Fed policy pertaining to interest rates have been generating of late. In the article, Hussman talks about the misconceptions that many investors have about the impact of interest rates on the return of the stock market. He takes on the view that low interest rates are always good and high interest rates are always bad. After reading this article one should have a pretty good understanding of how interest rates affect the stock market, but I feel that it is important to explain why the market reacts to interest rates in the way in which Hussman describes.

First, consider the situation where stock prices are at above average valuations and interest rates are low - returns are sub par when compared to the historical average. There is a logical explanation for this poor performance. Low interest rates are generally viewed as a good thing for the stock market, because of the way many stock pricing models are created. The primary example of this is a Discounted Cash Flow (DCF) model, which discounts future cash flows back to present in order to find a fair current value. One key component of a DCF model is the discount rate, which determines exactly how much less something is worth in the future as opposed to the present. If an investor is using some version of the Capital Asset Pricing Model (CAPM), then the discount rate is derived using a risk-free rate (such as a U.S. Government Bond) and the “risk premium” based on the specific risk of the company. Given that the lower the discount rate, the higher the current fair value will be, it is obvious that low rates will spur valuations to be elevated. The secondary factor - which I believe is almost completely overlooked – is the effects margin has on volatility. Low interest rates not only raise the net present value of future cash flows, but it also makes the use of leverage more attractive. The additional capital that can enter the system on margin can effectively place a bid underneath the market, hence reducing volatility. The last several years have seen an explosion in the usage of margin, which has coincided with a reduction in overall volatility. What does lower volatility translate into? Lower beta values - the variable which decreases the value of the “risk premium” part of the CAPM and makes equities seem to be even more valuable. This makes me wonder how many investment managers are overextended because their theoretical pricing models assume continued low rates and volatility, and the consequences that might occur if a rate increase leads to a series of sell programs and margin calls kicking in to place.

Looking at the effect interest rates have in equity pricing, it seems logical that having high valuations and low interest rates would lead to poor returns because interest rates do not generally stay at a low level, and when rates increase the fair value of equities decreases. On the other hand, if interest rates are currently high yet equities are trading at low valuations, this leads to a very promising situation because interest rates should eventually fall, spurring stocks to higher-multiple valuations. Unfortunately, that isn’t the situation we need to consider now. While interest rate changes don’t happen in a vacuum and aren’t inherently “good” or “bad,” the market and yield levels we are seeing now suggest that equities are likely to go through a period of poor performance.