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How Interest Rates Affect Stock Market Valuations

“Every thing in valuation gets back to interest rate.” – Warren Buffett

Interest rates can have a huge impact on the price that investors are willing to pay for different asset classes. For example, if interest rates are high, investors tend to favour lower risk, high yield investments like bonds over stocks and vice versa.

In the second part of the series on interest rates, I will look into how stock market valuations are affected by interest rates. The first part of this series looked at how interest rates affect business profitability.

Chase for higher yields

In investing, everything comes down to the risk-reward profile of the investment. When interest rate rise, the risk-reward for bonds become more attractive as yields are higher than when interest rates were lower.

Stocks, on the other hand, become less desirable because of two reasons. The first being the impact that interest rates have on businesses such as decreased consumer spending and increased cost of borrowing. The second reason is that other asset classes become more attractive as interest rates rise.

This can lead to an outflow of money away from assets like stocks and gold, and towards substitute investments like bonds and fixed deposits. The exodus, in turn, leads to depressed stock prices in a high-interest rate environment.

When interest rates drop

On the other hand, interest rate drops can have a positive impact on stock prices. Take, for example, the scenario of zero interest rates. Investors will have to find ways to achieve better yields outside of bonds, as they are getting zero returns on their investment when interest rates are at zero.

In theory, investors should be willing to pay a much larger amount to own a stock as each stock offers greater returns on investment compared to the zero-yield bonds. However, as we all know, interest rate fluctuates unpredictably and hence, investors still need to be cautious of the price they pay for a stock.

The Foolish bottom line

Movement in interest rates can affect investors’ sentiments and the asset classes that are more desirable at the point in time. However, long-term investors should take note that most of these interest rate changes will only affect prices of the asset class for the short-term. Furthermore, the theoretical relationship between stock prices and interest rates may not occur in the real world due to a whole host of other factors in play.

Moving in and out of the stock market based on interest rate changes is a risky business and probably best left to the experts. As individual investors, we should focus instead on the fundamentals of a company and ensure that we are not overpaying for a stock.

Meanwhile, for more (free!) investing insights, sign up here for your FREE subscription to The Motley Fool's investing newsletter, Take Stock Singapore. It will teach you how you can grow your wealth in the years ahead.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Jeremy Chia doesn't own shares in any companies mentioned.