Why are rising interest rates negative for stock prices? ~ [For Investment Beginners ] President Sheep's Gentle Explanation
President Sheep’s Gentle Explanation
Picking up key terms from finance and economic news! Aiming for an explanation as “soft and fluffy” as wool for investment beginners and those with no experience!
In the previous article, we explained the basic mechanism and purpose of “interest rate hikes (raising interest rates).”
This time, we will take a step further and unravel the meaning of the phrase often heard in the news: “When interest rates rise, it is negative for stock prices (a factor for decline).”
People often think, “That’s just because the interest on corporate debt increases and profits decrease, right?” but actually, that is not the only reason! Even if a company itself is working hard to increase its profits (growing), stock prices often fall for some reason.
The key to this lies in the relationship between the “future earnings forecast curve (angle of growth)” and “PER”.
This time, through the interaction between President Sheep and Little Lamb, we will gently unravel this mechanism!
š¤ Questions from the news ~ Why do stock prices fall even when profits are increasing?
Little Lamb:
“President Sheep! When interest rates rise and stock prices fall, it’s because the interest companies have to pay back to banks increases, leading to worse performance, right?”
President Sheep:
“Of course, that is one of the reasons. But you know, even when companies increase sales to offset the interest and are ‘properly increasing profits (profit growth)’, it often happens that stock prices fall’“
Little Lamb:
“What!? Even though the company is growing and making a profit, why would the stock price fall…?”
President Sheep:
“That’s because when interest rates rise, the ‘angle (slope) of the growth curve for the future’ becomes gentler. And, this ‘angle of the curve’ is the true nature of PER (Price-to-Earnings Ratio), which you often hear about in the investment world!”
š” The true nature of PER = “The angle of the future growth curve”
Little Lamb:
“Growth curve? Um… PER is an indicator that measures ‘how many times the stock price is being bought relative to the company’s profits,’ right?”
President Sheep:
“Yes! To be precise, it is a number that indicates ‘how many years of profit are expected based on the current term’s forecast profit.’ If the PER is 10 times, it means 10 years’ worth of profit, and so on. In other words, it’s like making a forecast on top of a forecast.”
Little Lamb:
“A forecast on top of a forecast… that sounds a bit vague…”
President Sheep:
“Exactly, stock prices are very vague things. That is why they are called a mirror reflecting the future and a leading indicator of the economy.”
Little Lamb:
“Hmm… a leading indicator of the economy? It’s getting difficult again…”
President Sheep:
“Then let’s change the expression. PER is a barometer of expectations that also forecasts profits for several years ahead. In other words, it represents ‘how excited investors are about the company’s future growth potential.'”
-
Steep upward curve (High PER):
A state where people expect “profits will grow rapidly from now on!” -
Gentle upward curve (Low PER):
A state where people expect “profits will be made, but the growth will be gradual”
Little Lamb:
“Wow! It’s easy to understand when you see it in an illustration!”
President Sheep:
“As you can see, investors don’t buy stocks just by looking at ‘current profits.’ They look at the future earnings curve that shows ‘at what angle it will grow from here on,’ and the steeper that angle is, the more they are willing to pay a higher PER (higher stock price) to buy it.”
š” When interest rates rise, the “angle of growth” becomes more gradual
Lamb-chan:
“I see! So, what is the relationship between interest rates and the ‘angle of the growth curve’?
President Sheep:
“This is the most important point! Depending on the level of interest rates, the ease of doing business in the world changes completely.”
1. During low interest rates (interest rates are low, almost zero)
Since money can be borrowed cheaply, companies can actively make new investments and expand their businesses! Because the circulation of money throughout the world also improves, corporate profit growth tends to draw a ‘steep upward slope (high growth rate)’. š Because the future curve is steep, the PER (expectation value) is also bought at a high price!
2. During high interest rates (when interest rates have risen)
The cost of borrowing money increases, and the movement of money in the world becomes more cautious.
Even if companies continue to grow, expansion at the same breakneck speed as before becomes difficult, and the way profits grow changes to a ‘gradual upward slope (slowing growth rate)’.
š Even if there is growth (increased profits), the PER (expectation value) is pushed down by the amount the angle has flattened!
š” The mechanism of ‘It is growing, but it falls because the angle has flattened’
Lamb-chan:
“Ah! It’s not that the company has ‘declined (red ink or decreased profits)’, but because the ‘angle of the upward slope has become more gradual’, the PER goes down!”
President Sheep:
“That’s right! Lamb-chan, you have wonderful comprehension!”
Stock price calculation formula :
Stock price = Current period expected profit (EPS) Ć Future growth angle (PER)
Even if ‘current profits’ have increased, if the ‘future growth angle (PER)’ flattens out due to rising interest rates, as a result of the multiplication,the stock price will fall.
Lamb-chan:
“It’s not that growth has stopped, but the ‘speed of growth (angle)’ has changed, so the expectation value goes down!”
š” Summary: How to deal with the waves of interest rates and stock prices?
Lamb-chan:
“When interest rates rise, the ‘momentum of growth’ of companies becomes more gradual. Along with that, the expectation value called PER also goes down.”
President Sheep:
“That’s right! In particular, growth stocks that were bought at a high PER based on the premise of ‘rapid future growth’ are more easily affected by this change in angle.”
š A word from President Sheep from an investor’s perspective!
The period of rising interest rates is also an adjustment period where the ‘expectation premium’ that had been growing at a steep angle until now is reset to a calm, appropriate angle.
The two stances you want to be conscious of as an investor are as follows!
-
Even if the angle becomes shallower, a “good company” is still a good company
It may be a shock at first glance to see the growth curve flatten and stock prices fall, but the company’s actual earning power has not been destroyed. Sometimes, this becomes a perfect opportunity to buy excellent growth companies at a “realistic stock price.” -
Focus on companies with strong “current earning power” (value stocks)
Under high interest rates, companies that are “already generating solid profits” or “have the financial strength to pay dividends” are more likely to be valued than those chasing rapid growth in the distant future.
If you understand the relationship between interest rates and P/E ratios, you will be less likely to panic when tossed about by market waves.
Let’s continue to learn gently together!
The biggest enemy of investment is “anxiety” caused by “not knowing”!
šPresident Sheep
š For those who want to know more! A recommended book
I would like to introduce a book recommended for those who say, “I understand the basics of interest rates and P/E ratios, but I want to learn more about the mechanisms of stocks and how to read indicators from the ground up!”
“The Easiest! Super Introduction to Stocks, 4th Revised Edition” (Author: Osamu Yasutsune)
A long-selling, super-standard book with over 1 million copies sold in the series!
From the very basics of “What are stocks in the first place?” to how to read indicators like the P/E ratio explained this time, and how to select stocks, this is a book you can read quickly like an encyclopedia with illustrated diagrams.
It is perfect as the “first bible” for investment beginners to pick up!
While some books labeled “Super Introduction” have stiff explanations, this series from Takahashi Shoten is mainly diagram-based and easy to understand visually, so I think it is the best fit for beginners!
šRead it now as an e-book
šRead it thoroughly in print
I am participating in the Amazon Associates Program.
P.S.
When interest rates rise, the “angle of growth” becomes shallower, so the stock market as a whole tends to have a heavy tone.
However, it is also an important process of shifting from a market bought solely on expectations of steep growth to a market that values grounded, real ability.
Don’t chase rising prices in a hurry or sell off in a panic; first, take a deep breath and let’s carefully assess the true strength of the companies!