Who is right? They are all right, at least partly, but their arguments divert attention from what should matter to value investors.
It is certainly true that, other things being equal, higher interest rates make stocks (and bonds) less valuable.
It is certainly true that the Fed directly controls short-term interest rates, while long-term rates depend on anticipated future Fed policies, inflation expectations, and more. When short-term rates increase, long-term rates sometimes go up even more, sometimes much less.
It is certainly true that the historical correlation between interest rates and stock prices is weak. The three main drivers of the stock market are the profits companies generate, the interest rates used to discount these profits, and the mood of the market (what Keynes called “animal spirits”). There is not a simple relationship between stock prices and any single factor, including interest rates.
The figure below shows rolling correlations between the monthly returns on the S&P 500 and long-term Treasury bonds from 1926 (as far back as these data go) through 2014. For each month, the correlation was calculated between the monthly returns over the preceding five years.
There has not been a consistent relationship. The average correlation over nearly a century was 0.13. There have been many years when stocks and bonds both did well and many years when they both did poorly. There have also been years when one did well and the other poorly.
However, value investors shouldn’t be trying to predict zigs and zags in stock prices. John Burr Williams, the grandfather of value investing, argued that the intrinsic value of a stock is the present value of the cash it generates: its dividends. In his view, investors should not buy stock unless they are willing to hold it forever, happily cashing the dividend checks. Williams, the Harvard economist temporarily turned poet, wrote:
A hen for her eggs
And a stock, by heck
For her dividends.
An orchard for fruit
Bees, for their honey
And stock, besides,
For their dividends.
If a city slicker comes to your farm and offers a low price for your cow, ignore him. You bought the cow for the milk, not to sell to city slickers. If the city slicker returns the next day and offers a ridiculously high price, more than the milk is worth, take advantage of his ignorance.
In the same way, Benjamin Graham created an imaginary Mr. Market, a person who comes by every day offering to buy the stock you own or to sell you more shares. Sometimes, Mr. Market’s price is reasonable. Other times, it is silly. There is no reason for your assessment of your stock to be swayed by Mr. Market’s prices, though you may sometimes want to take advantage of his foolishness.
Williams and Graham were both teaching us to form our own opinions of what a stock is worth, based on the income it generates, not on the daily fluctuations in stock prices. Think of a stock as a money cow, a cow that dispenses money instead of milk. The value of a money cow is the money it produces, not Mr. Market’s daily offers to buy or sell.
Similarly, Warren Buffett suggested that we think of stocks as disguised bonds so that we will value stocks by looking at their dividends the same way we value bonds by looking at their coupons. Another one of Buffett’s aphorisms is, “My favorite holding period is forever.” Even though we do not plan to hold stocks forever, by acting as if this were our intention we force ourselves to value stocks based on the dividend income, rather than hoped-for price appreciation. If forever is too hard to imagine, another Buffett variation on this theme is, “I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.” Again, the goal is to help us learn to stop guessing about ups and downs in stocks prices and focus on the income generated by the money cow.
The question today is whether the anticipated cash generated by stocks justifies their prices. One way to gauge this is to use the inverse of Bob Shiller’s cyclically adjusted price-earnings ratio (CAPE)—the cyclically adjusted earnings yield—as a rough estimate of the real return from stocks. This is currently around 4.5%. The real return from 10-year Treasury bonds is 1.5% with a 1% inflation, and lower for a higher inflation rate.
So, the question for value investors is whether a 3% risk premium is enough reason to stay in the market.
There are other ways to make such comparisons, including the valuation of projected dividends, but the conclusions are similar.
It would be foolish for a buy-and-hold investor to anticipate a double-digit real return from stocks over the next decade, but it would also be foolish to try to time the market by guessing whether stocks prices will be higher or lower tomorrow, a week from now or six months from now.
If you were to buy bonds or stocks today, which do you think will generate more cash over the next 10, 20, 30 years? Your answer will tell you which to buy.
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