INTEREST RATES & INFLATION
(November, 1999)
By: Arnold Van Den Berg

There have been many discussions about interest rates over the last year. We feel it is extremely important to understand the relationship between interest rates, stocks and bonds because the movements of one will affect the value of the other. While we will be discussing these relationships, we would like to point out that we try not to make predictions on interest rates, the economy or, for that matter, the weather. If you understand the relationship between interest rates and the value of stocks and bonds, you can adjust the price you are willing to pay for a company to include most unpredictable events, including changes in interest rates.

In the early part of my career, I spent a great deal of time pursuing information that would help me predict economic events, such as changes in interest rates and inflation, with very little success. Even in the rare instances that I made the correct predictions, it did not necessarily help me pick the right stock. In some cases, it actually hurt me as it prevented me from buying some companies whose stock price had already discounted the existing problems and future problems that never occurred, thereby missing some great opportunities.

It seems that part of human nature is always preoccupied about the future. Often times, people spend an inordinate amount of time trying to predict what lies ahead. It is for this reason that so much time and money is spent on astrologers and other forms of "soothsayers". "Wall Street", ever eager to cater to people's whims in order to sell their wares - namely overpriced IPOs (Initial Public Stock Offerings), regularly features these soothsayers as a substitute for sound investing.

Over the past 31 years, I have regularly observed these people come and go. Each market cycle seems to produce a person who has correctly predicted certain events or someone who has made good market calls. The news media aids and abets this process and eventually elevates these people to a level one notch below the divinely inspired. This process continues until they make a wrong prediction or a bad market call, at which time they are discredited and eventually forgotten. In the meantime, the public loses their money, never realizing that nobody can accurately predict the future. The people who have accumulated the greatest wealth in this business have done it not by predicting the future, but by buying companies at such attractive prices that they discount all of the problems that people fear and then some. And, as usually happens in life, as in buying stocks, most of our fears are never realized and you can find yourself owning a company at a price that already reflects the existing and future problems, most of which never happen. When some of the problems that investors feared never materialize, they find themselves with a profit for understanding that the money is made in buying great values, not in prophesizing about the future.

Influences on Interest Rates

There are several important relationships that tie inflation, interest rates, bond prices, and stock prices together. First, interest rates over any extended period of time are a function of the inflation rate. Second, bond prices are influenced by interest rates. Third, stock prices are influenced by changes in bond prices, as bonds are competition for stocks.

Inflation and Interest Rates

The most important thing that drives inflation is the amount of money that the government makes available to the economy. If the government makes excess money available, consumers bid up the prices of goods and services. This increase in prices causes a loss of purchasing power, which is inflationary. As people become aware that their purchasing power is decreasing, they demand higher wages. These higher wages cause more inflation, as wages are about 60% of the production cost of most goods. The reason everyone watches the Federal Reserve and its chairman Alan Greenspan so closely is because they influence how much money is made available to the economy.

Now that we understand some of the factors that cause inflation, we can see how inflation influences the level of interest rates. The reason inflation influences interest rates is that if you are going to lend your money, you want to make a profit on the transaction. Therefore, if the money you lend is losing its purchasing power at the annual rate of inflation, you want to have the borrower cover that loss for you and in addition, add a profit for the risk of lending the money.

The profit that lenders have required over and above the inflation rate has fluctuated between 1.5% to 6% at the extremes, and has averaged about 3% over the past 50 years. For example, if inflation is 3% and the lender's profit is 3%, you would expect a

30-year bond to yield 6%. If inflation increases to 5% and the lender's profit remains at 3%, you would expect a 30-year bond to yield 8%.

Inflation, Interest Rates and Bonds

We have just examined how an increase in inflation increases interest rates. Now, we will examine how a 1% change in interest rates affects your bond prices. Interest rates affect bond prices because a bond pays a fixed coupon payment equivalent to the prevailing interest rate, which we have seen is a function of inflation and the lender's profit. As an example, assume you purchase a $1,000 bond that pays $63 in annual interest for a yield of 6.3%. If interest rates increase to 7.3%, then your 6.3% bond would have to compete with the new bond that yields 7.3%. Since the coupon on the bond is fixed, the only way for your current yield of 6.3% to increase is for the bond to decline in value until the fixed payment of $63 equals a yield of 7.3%. In this example, the bond would have to decline 12% in value for this to happen.

Current Benchmark 30-Year U.S. Treasury Bond     October 22, 1999 Due: August 15, 2029 Coupon: 6.125% Current Yield: 6.35%
If Interest Rates Increase from the Current Level	The 30-Year Treasury Bond will Decrease in Value
1%	-12.0%
2%	-21.9%
3%	-30.0%
If Interest Rates Decrease from the Current Level	The 30-Year Treasury Bond will Increase in Value
1%	15.0%
2%	33.7%
3%	57.0%

On the left is a chart which illustrates what happens to the value of a bond that yields 6.3% (which is the current benchmark 30-year U.S. Treasury bond as of 10/22/99) if interest rates fluctuate between 1% and 3% from the current level.

Stocks, Bonds and Interest Rates

As we stated earlier, bonds are competition for stocks. The reason for this is that if you can get a guaranteed rate of return of 6.5% from a bond, you would expect to get a higher return from a stock to compensate you for the additional risk and uncertainty involved in stock ownership.

It is the uncertainty of stocks and the guarantee of the bond that are at the heart of the competition between stocks and bonds. When bond yields are more attractive than stock yields, you can expect investors to sell some of their stocks and switch them into bonds, thereby depressing stock prices. When stock prices decline to such an extent that they are yielding more than bonds, you can expect investors to switch back and buy more stocks.

Current S&P 500 Yields vs. 30-Year Treasury Yields

30-year T-Bonds are currently yielding 6.3%, so let's compare the return from bonds to the earnings yield of common stocks. Let's use the S&P 500 as our proxy for a basket of stocks. Currently (as of 10/22/99) the S&P 500 is selling at 1297 and has projected earnings of $55 per share. Let's convert the $55 in S&P 500 earnings to an earnings yield. This will give us an apples-to-apples comparison with the bond yield. To calculate this, we divide the earnings of the S&P 500 ($55) by the price of the S&P 500 index (1297) to get a stock earnings yield of 4.24% ($55/1297 = 4.24%). Now, we can compare the 4.24% stock earnings yield from the S&P 500 to the 6.3% yield from a 30-year U.S. Treasury bond to see which investment is a better value.

However, we still need to make one more adjustment to the earnings yield on the S&P 500 to make it truly comparable to bonds. The 6.3% yield on the 30-year Treasury bond is guaranteed, but it does not increase. The S&P 500 earnings do grow at an annual average rate of about 7% (the 50-year average). Therefore, we need to adjust the earnings yield of the S&P 500 to take into account that it is growing at 7% per year and eventually, this stock earnings yield (which is 4.24% growing at 7%) will equal the bond yield and then surpass it. At this level, it will take the S&P 500 earnings yield of 4.24% six years growing at 7% to equal a guaranteed 30-year bond yield of 6.3%. (See chart below.)

30-Year Treasury Bond		Years	S&P 500 Earnings Yield (Growing at 7% per Year)
Annual Yield	Cumulative Yield		Annual Yield	Cumulative Yield
6.3%	6.30%	1	4.24%	4.24%
6.3%	12.60%	2	4.54%	8.78%
6.3%	18.90%	3	4.85%	13.63%
6.3%	25.20%	4	5.56%	19.19%
6.3%	31.50%	5	5.95%	25.14%
6.3%	37.80%	6	6.36%	31.50%
6.3%	44.10%	7	6.81%	38.31%
6.3%	50.40%	8	7.29%	45.60%
6.3%	56.70%	9	7.80%	53.40%
6.3%	63.00%	10	8.34%	61.74%
6.3%	69.30%	11	8.92%	70.66%
It will take 6 years for the S&P 500 stock earnings yield, growing at 7% per year, to equal the annual yield of the 30-Year U.S. Treasury bond. it will take 11 years for the cumulative earnings yield on the S&P 500 to surpass the cumulative yield on the 30-Year Treasury bond.

Just from a common sense approach, why would an investor choose to invest in the S&P 500 index which has a 4.24% stock earnings yield, which will take 6 years to equal the 6.3% return on a 30-year guaranteed U.S. Treasury bond. The only conclusion that we can come to is that very few investors who are buying the S&P 500 index are comparing it to other stocks or bonds because if they did, they would realize that the index is overpriced in comparison.

Stock Yields & Bond Yields - A Historical Relationship

Let's examine the historical relationship between guaranteed bond yields and stock yields. The usual difference between a bond yield and stock earnings yield is about 1%. For example, if investors can get 6.3% on a guaranteed bond they are willing to accept 1% less, or a 5.3% earnings yield on a stock. The reason for this is that if you have a 5.3% stock earnings yield and it is growing at 7%, it will equal your 6.3% bond yield in about 3 years. Anytime thereafter, the stock earnings yield will increase by 7% per year. If you project this over several years, there is quite a difference and that is why investors are willing to accept an initial lower earnings yield on stocks, as thee earnings will continue to grow at 7%.

			(10/22/99)
Inflation Rate	2%	3%	2.1%	4%	5%
Add Lender's Profit (real rate of return)	3%	3%	4.2%	3%	3%
Equals Projected 30-Year T-Bond	5%	6%	6.3%	7%	8%
S&P 500 Projected Earnings Yield (E/P)	4%	5%	5.3%	6%	7%
S&P 500 Projected P/E Multiple	25x	20x	18.8x	16.7x	14.3x
Projected S&P 500 Earnings	$55	$55	$55	$55	$55
Projected S&P 500 Price	1375	1100	1034	918	786
Current S&P 500 Price (10/22/99)	1297	1297	1297	1297	1297
% Increase or Decrease	6.01%	-15.19%	-20.28%	-29.22%	-39.40%

The chart above illustrates the relationship between inflation, bond prices, the earnings yield and the price earnings ratio of the S&P 500. This will demonstrate how much the S&P would increase or decrease under the following scenarios. The column on the chart dated October 22, 1999 shows today's situation. Currently, inflation is 2.1%; the lender's profit is 4.2%, which gives us a bond yield of 6.3%. The equivalent stock earnings yield is 5.35%. This equates to an S&P 500 price earnings ratio of 18.8. If we multiply this (18.8) by $55 inearnings, we would get a price of 1034 for the S&P 500 (18.8 x 55 = 1034). Therefore, at the current price of 1297 for the S&P 500, this analysis suggests that the S&P is overpriced by 20.28%.

If you look at the chart below, you will see that the projected price of the S&P 500 index would be 1,100, based on a 6% interest rate. If interest rates were to increase by 1% to a 7% rate, the projected price of the S&P would go down to a price of 918. Thus a 1% rise in interest rates causes a 16.5% decline in the S&P 500 [(1100-918)/1100 = -16.5%].

Upon close review of this chart, you can see how important it is to understand the relationship between inflation, interet rates, bond prices and stock prices. It is because of the dramatic chain of event impacting various assets, which occur when there is even a 1% change in interest rates, that there is so much discussion about interest rates in the media. Again, you can see why the market declines and investors get so nervous when Alan Greenspan and the Federal Reserve meet to decide whether or not they should raise interest rates.

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