Image Credit: Christophe Vorlet
By Jason Zweig | June 17, 2016 3:23 pm ET
The yield on the 10-year Treasury sank beneath 1.6% this past week, within spitting distance of its record low of 1.4% in July 2012. How much should that change your estimates of what stocks and other assets are worth?
The impact of interest rates on stock prices might sound abstract. But in order to estimate your investments’ intrinsic value — how much all the money they are likely to generate in the future is worth in the present — you have to take interest rates into account.
Intrinsic value is “a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move,” wrote Warren Buffett in his 1994 letter to Berkshire Hathaway’s shareholders. “Despite its fuzziness, however, intrinsic value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.”
That value equals all the cash an asset should generate in the future, adjusted for the uncertainty and delay in receiving that cash — and how much you could earn by keeping your money in a so-called “risk-free” investment instead.
If you can earn a robust return on the safest asset, you should demand a much higher return to invest in anything that might go down in value now or won’t deliver gains until later. However, sitting on your money becomes less lucrative as the risk-free rate falls, making you logically more willing to invest in riskier assets that offer a chance at higher future returns.
“If the risk-free rate is lower, everything else being equal, that makes the same cash flows in the future worth more today,” says Robert Litterman, a founding partner at Kepos Capital, a New York-based asset manager that runs about $2.5 billion in hedge funds.
Divide expected cash flows by a risk-free rate of 2% — or 0.2% — instead of 4%, and you will get a significantly higher intrinsic value, unless you assume the stock has become riskier.
Mathematically, dividing by a smaller number produces a bigger result.
With the 10-year Treasury yield below 1.6% — and the 10-year inflation-adjusted, or “real,” yield, below 0.2% — “everything is expensive because this thing at the heart of the system has gone to all-time lows,” says Antti Ilmanen, a principal at AQR Capital Management, in Greenwich, Conn., which manages approximately $154 billion in assets.
As rates fall, risk tends to rise, because a greater proportion of stock returns has to come from capital appreciation. That is likely to make future investing results even more hostage to a continual bull market than you have been accustomed to.
Aswath Damodaran, a finance professor at New York University and an expert on valuing companies, points out that companies’ past earnings come from a period in which the risk-free rate was much higher.
So if, as many analysts do, you discount future cash flows using present interest rates while extrapolating earnings from a period of much higher rates, he says, “you get a dangerous mismatch” that can lead you to overstate a stock’s value by 25% to 30%. You can use past interest rates or today’s rates, but you can’t use both.
Surveys by Pablo Fernandez, a finance professor at IESE Business School in Madrid, Spain, show that the risk-free rates that experts use in their valuations haven’t come down as Treasury yields have dropped.
In his 2013 survey, when the 10-year Treasury yielded 2.0%, U.S. experts used an average risk-free rate of 2.4%. Their median rate, the number in the middle of the pack, was 2.2%.
By 2015, the 10-year Treasury yield had dropped to 1.9%, but the average U.S. expert still used 2.4% as the risk-free rate. The median assumption rose slightly, to 2.3%.
The variation in the rates they used in 2015 was enormous, ranging from 1.8% to 5.5%. Ten-year U.S. Treasurys haven’t yielded 5.5% since May 2001.
“Instead of going to the movies for fantasy, you can just read some of these reports,” says Prof. Fernandez. “It’s like they’re written by people from other planets.”
To stay safe, you could get out of the markets until rates finally rise. But “contrarian timing is hard to get right,” says Mr. Ilmanen of AQR Capital Management. “Expensiveness can last for quite a long time, and you can end up not just a few months early, but many years early.”
Emerging markets, he says, remain slightly less overpriced than developed markets such as the U.S.; decades of data suggest that so-called value stocks, trading at lower levels relative to earnings and asset value, have shown an ability to outperform in the long run.
Tilting your portfolio in those two directions should make sense.
“If you can only buy expensive things,” says Mr. Ilmanen, “at least buy a diverse set of them.”
Source: The Wall Street Journal