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Market Update

Will Low Interest Rates Continue to Fuel Stocks?

Depressed bond yields will likely make equity markets more attractive for a while.

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When the Federal Reserve slashed its Fed Funds rate in 2008 to almost zero, few thought we'd stay near these record-low yield levels all these years later. Yet here we are, with interest rates at a paltry 0.5%. This was supposed to be the year that rates would rise again, but with a sputtering global economy and some less-than-exciting domestic numbers, Janet Yellen has taken at least some additional rate hikes off the table in the near term. At this point, no one knows when rates will rise to normalized levels, or if they even will. Many people, like financial expert Dennis Gartman and Bank of Canada's Stephen Poloz, think we could be in an ultralow interest-rate environment for years, if not decades, to come.

While keeping rates low for long has implications on savings rates and borrowing costs, its biggest impact might be felt in the stock market, which has broken through record highs in large part due to the country's depressed rates. Since March 2009, when the S&P 500 hit rock-bottom, the index has climbed by 195% as of this writing. Of course, there are many reasons why stocks have done well, but a big one is that it makes a lot more sense to be in the stock market than the bond market. Given the low expected returns in bonds, it's easy to see how, even after a runup in prices, stocks can provide better total returns.

Many investors are now wondering what will happen to stocks if rates continue to stay at historically low levels. Will they keep rising? What if they get too expensive? Is high yield still the place to be? There are no easy answers to these questions, says Jim Sinegal, a senior equity analyst at Morningstar, as rates have never been this depressed for this long. Theoretically, though, low bond yields should continue making equity markets more attractive.

It's All About the Risk-Free Rate
Whether stocks will continue to do well comes down to what's called the risk-free rate, which now stands at 1.5%, says Sinegal. If investors are able to make money owning a near risk-free security, like a bond, then, naturally, they'd choose to own that investment over a riskier stock.

If interest rates were 5%, then more people would own a bond with that kind of coupon than a dividend stock that paid the same amount. With rates so low, though, no one can grow their retirement savings buy owning that risk-free bond, so instead they buy equities, which offer more perceived return potential. If the risk-free rate rises then that scenario might change, but if it doesn't then stocks should continue to be favored by investors.

At the moment, Sinegal doesn't see a reason why the Federal Reserve needs to raise rates. Inflation, a main factor in determining interest rates, is expected to remain below 2% for the foreseeable future. As well, the U.S. economy isn't yet booming, and companies are still reluctant to hire. Yellen has said that she'd like to raise rates, but if the data is not there to support a hike then she's going to stand pat, Sinegal says. 

"All signs point to caution," he says. "Why raise them if you don't have to?"

Short-Term Gains, Long-Term Concerns
If rates continue to stay low in the short term, stocks should continue to climb, says Rich Weiss, a senior vice president and portfolio manager with American Century Investments. Equities still look attractive on an expected-return basis; stock yields continue to be higher than bonds'; and earnings, which are what typically drive stock prices, are expected to rise next year. In addition, low rates have allowed companies to borrow money to buy back shares--U.S. stock repurchases are at unprecedented levels--which also pushes prices higher.

Longer term, though, persistent low rates could have a negative impact on markets, even if stocks continue to be the only way to make a decent return, says Weiss. That's because the Federal Reserve has said it would only raise rates if the economy can sustain it. If it doesn't hike, then that says there could be something wrong with the American economy. 

"If one expects rates to remain low for the foreseeable future, then that suggests a fairly dismal economic outlook," he says. "Then corporate earnings could be weak, and that's not good for equities."

Rethinking Valuations
Another consequence of low rates has been on equity valuations, which are now above historical norms. Many experts, including Yellen herself, have said valuations have climbed because investors have been willing to pay more and more for a dollar of earnings when faced with unappetizing choices in bonds or cash. Currently, forward price/earnings multiples are hovering around 18 times, above the more normal 15 times, says Weiss. While ratios aren't at astronomical levels, he says, there was a time when an overvalued market would be cause for concern.

Low rates, though, have altered the meaning of overpriced, says Mitchell Goldberg, president of ClientFirst Strategy in Melville, N.Y. 

"When you change the risk-free rate of return, you change discounted cash flow math, valuation math, and that impacts all kinds of equities and fixed income," he says. To him, valuations are essentially meaningless these days. He points out that a company like  Amazon (AMZN) has been overpriced for years, yet its stock is still climbing. There are also so many factors that go into a stock purchase that people can't simply rely on standard valuation metrics, and that's especially true in today's market.

Sinegal agrees that valuations are not as cut-and-dried as they once were, and that a low risk-free rate makes once seemingly high valuations much less scary. It's tricky, he says, because many investors do have to pay more for certain investments, but if something does happen to the market then those higher-valued stocks will still be hit the hardest. His advice? Listen to Warren Buffett, who said at his recent Berkshire Hathaway meeting that investors shouldn't go overboard. People may have to invest in something a little pricier than they have in the past, but anyone who buys something trading at, say, 50 times earnings is still taking a risk.

If one does believe that rates will stay low for long, it's still not a good idea to buy just anything today. Investors should stick to buying high-quality companies at reasonable prices, says Sinegal. He's finding opportunities in the financial sector, where many companies pay a dividend and where stocks are undervalued.  Citigroup (C), for instance, is one of his favorite bank ideas. Its dividend is in line with risk-free rate, but he says management has made plenty of progress since the recession and has raised a lot of capital. He also likes  Allergan (AGN) in the pharmaceutical sector; Sinegal notes that Allergan is a "very good company" with a strong track record of acquisitions. Goldberg, meanwhile, suggests owning more defensive consumer staples and healthcare stocks, which tend to do well in any economic environment.

Be careful around utilities and real estate investment trusts and interest-rate sensitive sectors that pay big yields and could fall if rates do rise. And don't chase the biggest yields--overly high payouts often mean something is wrong with a company. Whether rates stay low or not, Sinegal thinks people will have to more carefully consider what they buy. 

"There's going to be more of a focus on quality," he says. "You may have to be choosier than in the past, because everyone wants income and many stocks have been bid up, but there are still good companies out there."

Bryan Borzykowski is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.

Bryan Borzykowski does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.