The Biggest Reason Stocks Are at Record Highs

The Dow Jones Industrials (DJINDICES: ^DJI  ) are in line to finish their fifth straight winning year in a row, with gains of almost 23% in 2013 adding to a bull-market run that has sent the Dow up 140% since its 2009 lows. A big economic recovery helped stocks bounce back from their meltdown during the financial crisis, but the biggest factor supporting the bull market is the rock-bottom level of interest rates over the past several years. Following are four ways in which low rates have proven to be the biggest driver of share prices in the Dow and the broader market.

1. Low rates have forced many investors into stocks.
Before the financial crisis, many conservative investors relied on safe investments such as Treasury bonds and FDIC-insured CDs to generate the income they needed for their living expenses. With typical rates on CDs in the 4% to 5% range, many retirees and others who lived off the income from their investment portfolios could generate enough cash to survive at those rates.

Federal Reserve building in Washington, D.C. Source: Flickr Creative Commons (image creator: DonkeyHotey).

The persistent low interest rates from the Federal Reserve over the past five years or so have crushed savers, however, with rates on CDs falling to 1% or less. And although investors bear ultimate responsibility for choosing to raise their risk level to get more income, many have nevertheless felt forced to do so, shifting toward dividend-paying stocks. That phenomenon has pushed high-dividend stocks to high valuations, with Johnson & Johnson (NYSE: JNJ  ) and PepsiCo (NYSE: PEP  ) representing just a couple of the many above-average yielding dividend stocks with earnings multiples above 20 in light of huge demand for their shares.

2. Low rates boosted corporate profits because of refinancing.
Corporate earnings have driven the stock market higher, but in large part, companies boost their earnings because of low rates. Countless companies have successfully refinanced outstanding debt over the past several years at rates much lower than what they were paying on their old debt, cutting their interest costs and thereby raising their net income. Although those cost-saving opportunities haven't disappeared entirely, most companies have already gotten most of the mileage they can from refinancing, and so investors can expect one growth driver for corporate profits to fade away if rates start easing upward.

3. Low rates make stocks look more valuable.
Most stock valuation models use discount factors to put values on future streams of income. The lower the interest rate you use, the greater the value of expected profits well into the future. So with record low interest rates in recent years, it's been easy to argue for stock prices that represent much higher earnings multiples than normal.

Unless you expect those interest rates to be permanent, though, relying on them for long-term valuation purposes is dangerous at best. If interest rates start to rise, then the same factor that led analysts to overvalue stocks could make them overreact on the downside, punishing stocks in a much more severe correction than might be warranted under the circumstances.

Ben Bernanke. Source: Federal Reserve.

4. Low rates have made leveraged strategies more profitable.
Largely because of Ben Bernanke's policies at the Fed, rock-bottom short-term rates have made it easy for companies to use leverage to boost their returns. Some companies use leverage at the root of their business models, such as mortgage REITs Annaly Capital (NYSE: NLY  ) and American Capital Agency (NASDAQ: AGNC  ) , and for them, even the hint of rising rates has sent their share prices plunging recently in anticipation that the best rate conditions for those companies might be coming to an end.

More generally, though, companies have taken advantage of low rates to borrow for unusual purposes, such as doing share buybacks or paying dividends to shareholders. When rates rise, those strategies won't work nearly as well, leaving companies with the unappetizing decision of whether to reverse their earlier generosity or accept much higher costs in the future.

All in all, low rates play a huge role in the record run that stocks have made recently. If those rates rise further, it could put the Dow in serious danger of a reversal of some of its big past gains.

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Read/Post Comments (16) | Recommend This Article (22)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 10, 2013, at 10:45 AM, PEGformula wrote:

    Too bad Motley Fool and Yahoo Finance would never hire me - I would give the straight truth: Bernanke's unlawful manipulation.

  • Report this Comment On November 10, 2013, at 11:14 AM, dirksenshoe wrote:

    With the national debt in the financial stratosphere and if the only way for the Fed. Res. to support it is to have the Treasury print more money @ lower interest rates then it is highly doubtful foreign countries who are presently buying treasury notes now will continue to do so. As a matter of fact they will probably increase their present buying of commodities,strategic metals, oil, diamonds, and precious metals.This would necessitate a rise in our interest rates, leaving investors play musical chairs to decide when to jump out of the market before the music stops.This is something the average investor has little talent or inclination for. And if history is an accurate indicator of events, your average joe is being set up to take a fall.

  • Report this Comment On November 10, 2013, at 11:43 AM, glenns45 wrote:

    With the Fed printing 85 billion a month we are headed for hyper inflation and the collapse of the Dollar, Audit the Fed.

  • Report this Comment On November 10, 2013, at 11:55 AM, emilevid wrote:

    Finally an intelligent article with value to investors that actually help understand the present market dynamics. Quite a contrast to the daily self-serving pablum and distortions put out by Fools.

  • Report this Comment On November 10, 2013, at 12:01 PM, will1946 wrote:

    The problem with NLY, AGNC, and other reits is that they turned chicken and did not use leverage du;ring the last quarter, leaving us investors in them out on the ledge, especially if one has options in them.

    I think the most prominent reason you give is the first one: why should one give one's money to an institution which returns NOTHING, such as banks, bonds, and other worthless (for investors) fixed income instruments.

    Your article is pretty good.

  • Report this Comment On November 10, 2013, at 12:02 PM, marder1 wrote:

    Conversely, higher interest rates will drive mortgage rates up, killing the housing recovery, still 27% behind inflation, drive bond prices into the toilet to compete with CD rates, move people out of equities and into less "risky" investments, and plunge the markets world wide into chaos.

    See how that works.?

  • Report this Comment On November 10, 2013, at 3:30 PM, luckyagain wrote:

    marder1 - stated it correctly.

    Getting out of The Great Recession required either Federal deficit spending like what happened with WW II to end the Great Depression or super-low interest rates. Since Republicans were firmly against any spending except on wars, the Fed decided to try using super-low interest rates. Much better than letting the Great Recession morph into Great Depression II.

  • Report this Comment On November 10, 2013, at 6:01 PM, shineridge wrote:

    The economy is NOT recovering !! The rich are getting RICHER, but 90% of Americans are becoming LESS wealthy. Only 47% of adults have full time jobs. Most new jobs are part time, LOW wage jobs. Unemployment is over 20%. There are fewer Americans in the work force than there have been for DECADES. The economy absolutely STINKS !!!!!! And the only reason Fraud Street is up is because the market is just a total FARCE. Totally MANIPULATED. Period.

  • Report this Comment On November 10, 2013, at 11:37 PM, notraitor wrote:

    Bernanke has us in a bind. Interest rates can't go below zero and if the fed keeps buying treasury bonds, and other bonds that are relatively worthless the world will realize the emperor has no clothes. What will the fed do with all these bonds it has purchased? They will have to either hold them and take an interest rate and sometimes a default loss; or sell them at a loss.Other nations will dump treasuries, driving yields up. When the yields on bonds rise, both the stock market and the value of "bond mutual funds" will fall precipitously. People who are forced to short sell bonds will also lose money. Then the paper tiger of a stock market that Bernanke has created will not be able to sustain the retirees who had no choice but to abandon safer investments in order to survive. The mess will be worse than 1929-1932.

  • Report this Comment On November 13, 2013, at 10:23 PM, banmate7 wrote:

    Bernanke has it right. The leveraged crash of 2008 was as bad as the leveraged crash of 1929. Fortunately, economists are more knowledgeable and, ironically, poured on more debt in order to stabilize markets and labor in the aftermath.

    We're in a recovery, albeit a painful one. Most macroeconomic metrics are trending positively, even the rate of debt increase. Valuations are fair. There isn't excessive leverage.

    Sure, we're in deep with QE. But most of the recently created money sits on bank books as reserves. It is not being lent out. It certainly is not making its way into the stock market.

    The author of this article correctly notes that low interest rates are a strong enough driver of the stock market. But I believe he overstates the impact here. As I said, valuations are fair to frothy, but nothing like 1999. Earnings are real. Global aggregate demand is rising.

    The wild card? Ending QE. Again, the fed has a good plan. Selling bonds back means tightening money supply, inflation fighting, rising rates, and a strengthening of the dollar. This makes the US even more of a safe haven, complemented by the fact that eager buyers continue to buy our debt.

    As to stocks, consider that the bull run of 1982 - 1999 featured much higher interest rates. A flourishing stock market and relatively higher rates are not incompatible.

    Lastly, look at the US from a corporate perspective. Our innovative companies dominate every supply chain on the planet. We're combing domestic energy & 3D printing to reinvigorate an industrial base that already produces 40% of global manufacturing GDP. The US is basically an IMMENSE cash flow engine. And just like with companies, cash flow is king!

    We're emerging from a secular bear that started in 1999 and a devastating leveraged crash in 2008. I'm seeing the beginning of a secular bull...especially if captains of industry and politicians meaningfully collude on jobs.

    Jobs are the real wild card. But that's a different story. All the best best!

  • Report this Comment On November 14, 2013, at 8:41 AM, wrldtrvlr wrote:

    The market is going up for the same reason it always does - expansion of the money supply. As long as our private corporation known as the Federal Reserve keeps with its QEs, the U.S. markets will move higher.

    Conversely, once the money supply starts contracting, the market will turn.

  • Report this Comment On November 14, 2013, at 11:42 PM, blablableh wrote:

    You lost me at the second sentence --- "A big economic recovery" with a hyperlink that does not support the point you are claiming it supports. We have not had a "big economic recovery." It has been modest at best. I am fast losing faith in these MF articles. The quality really is not there.

  • Report this Comment On November 15, 2013, at 11:11 AM, banmate7 wrote:

    @hjsm Nearly every macroeconomic metric has trended positively. GDP. Employment. Distribution of income is getting less skewed, as it was seriously hurt by the crash of 2008 & associated losses in of jobs sensitive to the housing supply chain. Market indices have risen. The US still produces 40% manufacturing GDP and is growing here.

    If you do some research, you will also find that lending has flat lined in the past few years, whereas bank reserves have increased. This basically confirms that QE money isn't being lent out. Aside from low interest rates associated with QE, there is no effect on the stock market here. The money is inert. The money supply effectively has not increased by much. Don't get me wrong, we printed money, but it isn't circulating, explaining to some degree why inflation remains tame. And as I explained in a previous post here, the odds are good QE bonds will successfully be sold back once the program unwinds.

    The biggest challenge is fixing the jobs situation. Although trending positively, this has been slow & painful. There is a difficult skills gap for 3 million blue collar jobs & a high number of hi-tech jobs that remain unfilled. This is another unfortunate consequence of our collective debt abuse, which allowed some Americans to stay in jobs that otherwise were not sustainable...and not easily transitioned into new economy jobs.

    My take is that we are on the cusp of a secular bull. It might take 1 - 3 years to get it going. BRIC countries and emerging markets are pausing. The US spy scandal is actually hurting our tech companies abroad. But there is real pent up demand and real wealth owned by growing middle classes all around the planet.

    North American corporations still dominate every supply chain. If anybody benefits here, it will be these companies. I've loaded up since 2006 in North American companies, especially energy, transport, & retail. I'm now going after technology & infrastructure, especially if they're internationally exposed.

    I'm buying into INTC, IBM, GLW, GTAT, and CAT most recently. Best of luck.

  • Report this Comment On November 16, 2013, at 2:36 AM, willesalt wrote:

    I have spent years looking at so called experts and not invested as I wanted to lose no more money in the stock market, I no longer understood it.

    I ran across the Gardner's and the Motley Crew investing strategies and decided their research and reasoning was the first reasonable approach to investing I not only liked but felt I could trust. I am not one who believes that retired people have to limit their earnings to managers who feel a 4.5% to 6% earnings is of any value unless you have millions.

    The safest investment in my opinion is not one designed to protect your assets garnering few if any gains. There is no such thing as protection through defensive investing. Why not invest to make money in a 'common sense' way as outlined by The Motley fool.

  • Report this Comment On November 16, 2013, at 5:15 AM, DJDynamicNC wrote:

    With GDP the highest it's ever been (in nominal terms) it should come as no surprise that stock markets (denominated in nominal dollars) are also at record highs. It's as simple as that.

  • Report this Comment On November 16, 2013, at 5:16 AM, DJDynamicNC wrote:

    "With the Fed printing 85 billion a month we are headed for hyper inflation and the collapse of the Dollar, Audit the Fed."

    Now where have I heard that before? For like, oh, two hundred years or so?

    I'm sure this time it really is just around the corner though.

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