The Interest Rate Cycle Acts As the Backdrop to Any Meaningful Valuation

Dear Reader,

Everywhere around us, the debate about bubbles continue. Are we in another bubble…or is this the new norm?

The stock market indices continue to grind higher. Even the Aussie market has finally joined the party. And property, whose trajectory peaked a couple of years ago, is now back on the up and up.

Auction clearance rates are up. Median prices are now within a whisker of their 2017 high. That’s all nice and dandy if you’re an owner of both asset classes.

However, are these prices sustainable…or is this the last hurrah before the whole thing comes crashing down around our ears?

If you’ve been reading these pages for a while, you won’t be in any doubt about how my colleague here, Vern Gowdie, answers that question. Vern is as sure as he’s ever been that the whole damn thing will end in a bust.

Even if you don’t agree, it’s sure worth hearing what Vern has to say.

The driver of such high valuations — whether they be shares or property — comes back to one thing…interest rates. It’s a narrative with which we are all familiar.

Sure enough, there are other factors as well.

Earnings growth, margins, profits, market share and a myriad of other numbers help determine how a company is performing. It’s these numbers that drive the day to day price movement of shares.

However, interest rates determine how we value these companies. That determines whether something is ‘expensive’ or ‘cheap’.

It’s something that Warren Buffett spoke about as far back as 1994 at the annual Berkshire Hathaway meeting. At the time Buffett said:

 ‘So every business by its nature…its intrinsic valuation is 100% sensitive to interest rates.

It’s this very same quote that Hamish Douglass shared with Magellan investors in an article, ‘The gravity of interest rates’, in August last year. And again, something he explored more recently at the annual Magellan roadshow.

I doubt that Buffett’s view will have changed since making that quote over 25 years ago.

If interest rates were 10%, there is no way value investors like Buffett and Douglass would value Apple at US$300 per share — where it has recently traded.

Nor would they value Amazon at over US$2,000 a share — no matter how rapidly it is growing.

And it is this dichotomy that fuels the debate about value.

So much of the debate about value focuses on short term numbers. However, it’s the broader interest rate cycle that acts as the backdrop to any meaningful valuation.

The value of future cash flows…

The higher interest rates are, the less valuable a future cash flow will be.

As Buffett continues:

‘…all you are doing in investing is transferring some money to somebody now in exchange for what you expect the stream of money to be, to come in over a period of time, and the higher interest rates are the less that present value is going to be.’

In other words, the higher rates are, the more interest income an investor is forfeiting by handing their money over to someone else.

As rates have gone from double to single digit — and now to near zero (and even negative in many countries) — the value of future cash flows has just about become meaningless.

Even the poor old yield curve has lost its curve — it’s just about flat.

As an investor, the longer you tie your money up, the more you want to be compensated. That’s why typically, the yield curve is positive.

Only does the prospect of a huge economic downturn cause the yield curve to ever invert itself, upside down.

However, with a flat yield curve, it makes no difference how long you tie your money up.

The short-term rate in the US? A range of 1.5% to 1.75%.

And the yield on a US 30-year bond? Try 1.89%. That was the going rate on US 30-year bonds issued at the end of last week.

Who would tie your money up for 30 years just to gain an extra 0.1 to 0.2 of a single percent?

The answer is…anyone looking for yield. They fear that the yield could be lower next time round.

That is the prospect ahead. And it is why conventional ‘wisdom’ has gone out the window. While short-term US rates might not go to zero anytime soon, it’s quite possible for the back end of the yield curve to go to zero…even negative.

But what about those countries where short-term rates are already negative? Where an inverted yield means you will get paid more interest the more you borrow, and the longer you hold that debt.

As an investor, even if the business barely breaks even, why wouldn’t you fork out money to invest? To get paid to borrow money to buy whatever asset you can.

As an investor, surely this is the best game in town. How can you default on a loan when you are getting paid to borrow money?

It’s by far the closest thing you will get to perpetual motion in the financial markets. Yep, it all seems a step beyond reality…maybe a lot more than a step.

But that is what we all face. Sure, watch profits, margins and all the other numbers on any share you wish to invest. But watch interest rates more closely than ever.

As we saw a couple of years ago, even the slightest rate rise — or even the prospect of one — will pull the rug more quickly than any black swan event.

All the best,


Signature
Matt Hibbard,
Editor, The Rum Rebellion

PS: Interest rate cuts will trigger the next global financial crisis. Here is what you should do now to protect your wealth.


Matt Hibbard is The Rum Rebellion’s income specialist. With nearly three decades in the markets, Matt has traded just about every asset class there is. The one thing that has stuck with him over this time is a very simple premise. That is, it’s the cash a company generates that ultimately determines its value. Sure, some stocks might fly away to multi-digit gains. But unless these companies can convert the ‘story’ into real money, the market will eventually find them out. And when that happens, the share price quickly falls back to Earth. Matt is also the editor of Options Trader, where he shows subscribers how to use basic options strategies to generate income. This is income they can generate on top of regular dividend payments. Matt doesn’t play the prediction game, where the aim is to be proven ‘right’. Instead, his goal is to generate as much income as he can for his subscribers, irrespective of whether the market is going up or down.


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