As with hard sciences like physics or chemistry, finance has commonly held “principles” somewhat akin to laws that help govern how investors value assets. The difference is that finance is not a hard science but, like economics, more of a social science that relies on human behavior and psychology. As a result, even the most widely accepted tenets deserve to be examined and turned on their heads at times to evaluate under what circumstances they actually hold up. In this article, we do just that with the relationship between equity valuations and interest rates. What we learn is that changes in interest rates sometimes lead to inverse changes in stock prices, but the economy is often the more important determinant for both interest rates and stocks.
The rule of thumb is that interest rates have a direct, inverse impact on equity valuations. That is, when interest rates are lower, equity valuations could, or even should, be higher. We saw this play out in the late 1990s, as interest rates fell and equity price-to-earnings multiples climbed to record highs. The converse is also deemed to be true, as was the case between mid-2017 and 2018, when the 10-year Treasury yield climbed by almost 1.25% while equity valuations fell (Figure 1). However, as is evident from the chart, this relationship is not always consistent. Allow me to explain.
Please see important disclosures at the end of the article.