Shares are almost always priced at a premium to the yield on risk-free assets. As an example, we can take a look at the Singapore and U.S. market. In Singapore, a risk-free asset can be taken to be 10-year government bonds. At present the bonds are yielding around 2.3%. Meanwhile, Singapore’s share market, as represented by the SPDR STI ETF (SGX: ES3), has an earnings yield of 7.5%; the SDPR STI ETF is an exchange-traded fund which aims to mimic Singapore’s market barometer, the Straits Times Index (SGX: ^STI). As for the U.S., a widely-used proxy for a risk-free asset…
Shares are almost always priced at a premium to the yield on risk-free assets. As an example, we can take a look at the Singapore and U.S. market.
In Singapore, a risk-free asset can be taken to be 10-year government bonds. At present the bonds are yielding around 2.3%. Meanwhile, Singapore’s share market, as represented by the SPDR STI ETF (SGX: ES3), has an earnings yield of 7.5%; the SDPR STI ETF is an exchange-traded fund which aims to mimic Singapore’s market barometer, the Straits Times Index (SGX: ^STI).
As for the U.S., a widely-used proxy for a risk-free asset would be the U.S. 10-year Treasury, which is currently yielding around 2.3%. The Dow Jones Industrial Average, one of the country’s oldest market indexes, is valued at 16 times earnings, thus giving rise to a 6% earnings yield.
Rising interest rates equals falling shares?
In order to preserve this premium to risk-free assets, the logic thus follows that if interest rates rise, share prices would have to fall (when shares fall, their earnings yield increases). This is also where some investors are seeing danger for the share market.
With risk-free assets in Singapore and the U.S. carrying yields that are at generational lows, and with the U.S. Federal Reserve ending their massive bond-buying programme recently, the predominant view is that there’s nowhere to go for interest rates but up. So if we follow this train of thought, the best thing to do now would be to sell our shares.
Hold on! No rash actions here allowed
But as logical as the causal chain of events might seem, history actually tells us a different story. In 2012, Vanguard did a study to see how well certain economic and financial indicators fared in predicting future long-term stock market returns. The study had used market data going back to 1926, so that’s a long look at history.
Source: Morgan Housel at fool.com
The chart above shows the results of Vanguard’s study. One of the variables used was the 10-year Treasury yield, and as can be seen, it basically couldn’t at all predict what the markets will do next.
Put another way, where interest rates are right now, would likely not be able to tell us what the markets would do going forward. The financial market is a way too complex beast for investors to try and predict what can happen next because of the way a certain variable has changed. Or as investor Howard Marks once said, “One thing you can never be sure of in the investment world is <<if A, then B>>. Processes and linkages are not always predictable.”
A Fool’s Take
In light of the above, I wouldn’t be in a hurry at all to sell my shares if interest rates eventually do rise (on a related side-note, it’s hard to even tell if interest rates would rise). Instead, my selling decisions would be guided – as always – by changes in the strength of the businesses that underlie my shares. Although I mentioned earlier that the financial market, as a whole, is too complicated for single-variable analysis, individual shares do tend to follow a simple dictum which is succinctly enunciated by Warren Buffett: “If a business does well, the stock eventually follows.”
So, keep your eye out on business-changes and not on interest rates.
Knowing about the relationship between interest rates and the share market is important. But there are also other important things to know about in investing. If you'd like to find out more, we at The Motley Fool Singapore have prepared a report titled What Every New Singapore Investor Needs To Know . It is a quick five to 10 minutes read on what's really important about the share market and is a great guide for both new and experienced investors alike regarding the basics of the market.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn’t own shares in any companies mentioned.