EC The Threat And Risk Of Rising Interest Rates: Separating Fact From Fiction

Additionally, the other factor that should be considered in this analysis is the growth of earnings that transpired during that timeframe. Therefore, once stock prices became more in alignment with fair value, long-term growth of earnings generated positive shareholder returns in spite of lower P/E ratios for the S&P 500. Furthermore, we also see the effects of falling earnings during the Great Recession driving stock prices temporarily lower.

 

Johnson & Johnson (JNJ )

Although the factors that drive returns and affect stock valuations are interesting and useful to evaluate by looking at the overall market, I believe they are more pertinent when evaluating individual stocks. The following P/E ratio versus interest rates graph on Johnson & Johnson illustrates a similar relationship of falling stock valuations in conjunction with declining interest rates. As I will illustrate next, high valuation was once again the headwind that defied logic.

 

Just as we saw with the S&P 500, Johnson & Johnson was also overvalued in 2000 and stayed that way until 2007. However, the big difference between Johnson & Johnson and the S&P 500 is that Johnson & Johnson’s earnings grew much more consistently over this historical timeframe. It is important to note that Johnson & Johnson’s stock price reverted to the mean of fair value (touched the orange line) in the early spring of 2007 and then became undervalued in 2009.

 

In economic theory they have an important qualifying phrase “Ceteris Paribas” which loosely translates to all things being equal.  What this suggests is that economic theory will typically work as planned as long as all other factors are within normal ranges. Consequently, when you examine the P/E ratio versus interest rates graph on Johnson & Johnson since the beginning of 2009, you discover that the theory of the inverse relationship is intact. As interest rates continued to fall, the P/E ratio of Johnson & Johnson -and with it its stock price – increased in contrast. All was well with the universe once again.

 

When we review the earnings and price relationship of Johnson & Johnson over this same timeframe, additional insights are revealed. Here we might be safe in assuming that interest rates played a role in Johnson & Johnson’s increasing P/E multiple. On the other hand, we cannot deny the role that undervaluation coupled with steadily increasing earnings (and dividend growth) played. Interest rates are an important factor, but they are just one among many important factors that drive stock prices.

 

Additional Individual Stock Examples

For additional insight, I offer several additional examples of blue-chip Dividend Aristocrats to illustrate that the relationship between interest rates and P/E ratios is not always neat and tidy. As you evaluate each of the examples, take note of the differences in operating results and historical valuations on each. Interest rates do play a role in every case. However, there are other factors that also come into play and at times can be the dominant factors.

Valuation levels are the critical element to be aware of. The reason I bring this up is because low interest rates have contributed to a high level of demand for blue-chip dividend paying stocks. Consequently, valuations on most of the best-of-breed dividend growth stocks have become historically high as illustrated in the examples below. Moreover, the moral of the story is that these overvalued Aristocrats might be the most sensitive to rising rates if they do manifest in the future.

McDonald’s Corporation (MCD)

 

 

The Procter & Gamble Company (PG )

 

 

Lowe’s Companies Inc (LOW)

 

 

3M Company (MMM)

 

 

McCormick & Company Incorporated (MKC)

 

 

McKesson Corporation (MCK)

All of my previous examples were Dividend Aristocrats that appear currently overvalued. However, this last example presents a company in the healthcare sector that appears undervalued. The healthcare sector is generally an out-of-favor sector currently. Therefore, this illustrates another factor that comes into play. It is a market of stocks not a stock market. Moreover, generalities can provide some utility and insight. However, a deeper analysis of specific companies you might be considering is more relevant than relying on generalities. There are undervalued stocks in today’s generally overvalued market.

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Disclosure:  Long PG, MCD, MCK, JNJ

Disclaimer: The opinions in this document are for informational and educational purposes only and should ...

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Elliott Morss 3 years ago Contributor's comment

Chuck:

Thanks for your interesting piece. Just a couple of points I would mention:

1. Many have noted that P/E ratios are getting high relative to historic P/E. I would mention that the US has been the place for the world to invest. And this upward shift in demand will increase the "P" in the P/E ratio. So perhaps we should expect a higher P/E ratio going forward for US stock markets.

2. I am wondering how effective the Fed can really be in raising US interest rates. There is a healthy demand now for US Federal debt, and higher debt will certainly increase the demand for US debt.