Before We Start
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The Current Market
As I am writing this post, we’ve been in a period of low interest rates for a long time. Stocks have been climbing up and up and up. I recently read an article in the Globe and Mail by George Athanassakos. It reminded me how much I struggled with understanding the correlation between interest rates and prices in stocks, but also real estate.
An Example With Real Estate
The easiest way to explain how interest rates affect prices is by using real estate as an example.
As a human being, you generally have 3 main choices when it comes to finding a place to live:
- Live with someone for free (like we do as kids/teenagers)
- Pay rent
- Own a home and pay a mortgage
When you own a home, your mortgage payments are based on interest rates.
For the sake of simplicity, say you borrow $100,000 from the bank at a 1% interest rate to buy a home. That means you pay them 1% of $100,000 each year, or $1000 a year or $83 a month.
Most of us can afford that.
As a general rule, most people spend 25–30% of their income on mortgage payments. In Canada, the average annual salary is $55,000 a year. Their take-home income is about $42,500 after tax. That means they earn about $3550 free and clear, after tax, each month. If there are two people earning an income in a household, that number becomes $7100. Let’s call it $7000 to keep it simple.
Of course, you can only buy a house you can afford. The bank would never qualify you for a mortgage if you can’t afford the mortgage payment because the bank makes their money when you pay interest, reliably, month after month, year after year.
The Math On Mortgages
So the bank will typically only qualify you for a mortgage of 25–30% of your take-home, after-tax income. In this case, this couple can afford say 30% of $7000, or $2100 a month on housing payments.
Now let’s pretend the mortgage on the house costs $700,000 after their down-payment.
In a 10% interest rate environment, they would pay $70,000 a year, or $5833 a month. They would never qualify for that house as it represents 83% of their after-tax income. They would have a hard time paying those payments and surviving.
In a 1% interest rate environment, they would pay $7,000 a year, or $583 a month.
Human Nature
One day, the happy couple might look at each other and say:
“Hey we have $7000 a month, and this place is just OK. We are saving $6000 a month. Why don’t we invest in a better home? We can afford the payments, and besides, houses always go up in value.”
So, they talk to their mortgage broker and viola, it turns out they can qualify for up to 30% of their combined after-tax salary. So they can spend up to $2100 a month. They feel rich!
So, they go house shopping. The mortgage broker (and their realtor) assure them that house prices will stay low for a long time and can only move up slowly, so they feel confident about their purchase. They can afford $25,200 a year, which is a mortgage payment of $2,500,000 at 1% interest rates.
This Creates A Trend
Since people tend to mimic each other, they see other couples posting photos of new homes and condos on instagram and they want one too. Since the professionals at the banks and mortgage brokers say it’s okay, they feel safe. “Besides, houses are such a safe investment, they never go down” they think.
So, they are willing to pay more to get more. As everyone does this at once, it eventually causes the price of all real estate to rise due to supply and demand.
Over The Long Run, Low interest rates don’t help you afford more, they just devalue money
Over the long run, these low interest rates make everyone feel richer, so they take on more debt and they spend more money. Eventually though, money in general loses it’s value because everyone feels richer and feels they have more of it to spend.
Most of the money in the economy is actually credit, and since low interest rates push up asset values, people feel richer. Banks and lenders get sucked into this too due to human nature and as they see asset values rise, they tend to relax their standards, making it even easier for more people to borrow more money, for more expensive assets at lower rates.
Why We Have Cycles
This entire cycle feeds on itself until people have so much debt, they can’t pay it off, despite low interest rates. I believe this is happening in Canada right now, because monthly mortgage payments have gone from $1100 a month to $1450 a month, a 32% jump in the last 5 years ,despite salaries staying relatively flat. Low interest rates encourage humans to pay more since they feel they can afford more.
Simplifying This Whole Post
When interest rates are low, people feel richer because their monthly payments are lower. This causes them to spend more, until they get to the limit of affordability. It’s human nature to maximize your lifestyle as the majority of us cannot defer gratification now for gratification later. So, we max out what we can do right now, and this leads to prices driving up. Since all prices are going up at the same time, it actually just devalues money. The end result at the top of the cycle is we are paying more money for worse assets than ever before and we are taking on high risk to do it. This is a situation where there is low upside (not much to gain) and high downside (a lot to lose).
What Does This Have To Do With Stocks
Stocks are fractional ownership shares in businesses and businesses need debt and equity to finance their operations.
If you invest in a company, either by lending them debt or buying equity in the business, you are giving them cash now in the hopes they will pay you more later. That is what investing is.
The only way a company can pay you more later is if it earns more money than it spends. The difference between its costs and its sales is the earnings. Over the long run, a business must generate earnings to pay its lenders and shareholders back.
If a business sells $100B dollars worth of goods but it only earns $1B in sales, its “earnings yield” is only 1%. Investors want high earnings that are stable, consistent and reliable. They want to give the company some now to get more later — as much as possible, for as long as possible, with as much stability as possible. Don’t you want a money machine that never stops paying you back? Of course, we all would like that.
But investors are just like the couple earlier in the post. They compare themselves to all the other investors. Investors look at all their alternatives to investing in stocks. For example, they might compare stock returns with10 year government bonds. The government bonds would give them a return without any risk, so they normally compare stock investments to the bond rate.
When the bond rate is very low, say 1%, and stays that low for many years, stock prices go up for the same reason real estate prices do. There is more money (credit) being thrown at the stock market and people are hungry to get a return on their money. As time goes on, they pay and more and more money for lower and lower returns. Other investors do the same thing causing the prices to skyrocket.
People like to believe that their decisions are smart, so they also tend to think the companies they invest in are good — why else would they invest in them right? Therefore, they start to predict that these companies will grow at rates that will justify their valuations.
What Does It All Mean?
All this means is that low interest rates mean high prices. Not always, but generally as a rule. Long periods of very low interest rates mean very high prices. Paying a lot of money for something means you are expecting a very bright future. But if the present is already extremely expensive, and people are already spending the maximum amount of money they can, why should the price go up? It doesn’t have anywhere to go but down.
There is a measurable correlation with high prices and low returns.
Low interest rates = More spending
More spending = Higher prices
Higher prices = more risk
More risk = lower upside potential and higher downside potential
What Is The Solution
I believe the best way to invest, is to invest in the earnings yield at it’s present cost. I also believe that you should use 6% as the historical average interest rate. I ran the numbers in Canada over the past 100 years and the median interest rate over that period was 6% (the average was 7%).
Personally, I think it makes more sense to budget using average market conditions than to pay up and hope they stay low forever — that seems unrealistic.
I’ll give an example with real estate and the couple from earlier in the post (earning $7000 a year).
Let’s say a house costs $400,000 and I have $100,000 down. The mortgage is therefore $300,000.
I would budget the mortgage payment at 6% of $300,000. That would be $18,000 a year or $1500 a month. Thats 21% of the couple’s after-tax salary, so in this example, they could even spend a little more.
Having said that, I wouldn’t stop there. The value of an investment is the earnings yield on the original down-payment. So they are investing $100,000 to earn a return. I would ask myself, what return can the couple earn from renting this house out, net of expenses?
What Are The Expenses?
Maintenance
Legal Fees
Mortgage Payments
Management Fees
Etc.
Let’s Say For The Sake Of Simplicity The Expenses Are $200 Per Month On Top Of The Mortgage Interest.
That would be a total of $1500 + $200 = $1700.
If the couple could rent the home out for $3000 a month, their net income would be $1300 a month.
$1300 X 12 = $15,600 a year.
$15,600 a year on a $100,000 down payment is a 15.6% return.
This is a good return considering the S&P500 has earned roughly 10% on average. Still though, the couple should compare the yield they’d earn on this home with all the alternative options for their money, accounting for uncertainty and risk in their calculation.
What About The Value Of Growth?
One common thought on this is that real estate values will grow. I would argue that ultimately real estate values will trail growth in incomes. Income growth will trail GDP growth.
GDP growth in Canada has been about 3.5% a year, so at most, you could value the house at 3.5%. That means if you expect to earn 15.6% a year on your down payment of $100,000, you’d actually earn 18.6% with the growth.
Be careful valuing growth though because the future is unknown. If interest rates doubled to 12%, the house would theoretically be worth half as much, since it would be generating half as much income. That would affect your return. Keep in mind too that inflation is around 2–3% per year, so the GDP growth and inflation in the long run override each other.
Why Asset Prices Go Down When Rates Go Up
When rates go up, asset prices go down. At 20% interest rates, a house that was $2,000,000 in a 1% environment might be worth half that, or even less. This is because the monthly mortgage payment is so high, nobody can afford it and therefore nobody can buy it.
With stocks, that high interest rate means you can make 20% virtually risk free by investing in a government bond. Why would you invest in a stock that can earn 10% at all if bonds can pay that much? This drives the price of stocks down as investors move their money towards the zone of highest return.
This is an extreme example, but interest rates have been that high in the past and they could go that high again. If you are a long term investor, it is important to be aware that the historical average rate is 6%. Therefore, in times of low interest rates, one of my favourite investors Joel Greenblatt advises to use 6% as your interest rate when making investment decisions when the interest rate is 6% or lower.
In Summary
When you pay too much, your returns are lower and your risk is higher. This is what happens in low interest rate environments. The longer the low interest rates persist for, the more “normal” they appear and the bigger the bubble gets. Nobody knows when a bubble will pop, and I cannot say where we are at in the market cycle.
What I can do, is look at the price I am paying for an investment, whether it is a house or a stock, and calculate my annual yield for paying today’s current price. If my yield is very low and my price is very high, while rates are already low, the odds that I am overpaying (and may lose money) are quite high.
Overall — I believe we should be cautious when rates are low, because we risk overpaying for assets that have poor yields. When rates eventually rise (and they have to, or we will have inflation), asset prices will go down and monthly payments will go up.
Paying higher monthly payments for something that is worth less and less every day would be a terrible feeling. But this is exactly what happens eventually when you overpay in a low interest rate environment.
Notes
- I oversimplified the cost of a mortgage because I only listed the interest payments — of course in real life you’d pay down the principle too
- As you pay down the principle, the monthly interest payment would be less over time as well — I left this out of the math for simplicity
- Canadians also in general pay $500 a month for a vehicle, hold $2000 of credit card debt and have a $200 per month credit card bill
- HELOCs — Home Equity Line Of Credits are also going up as interest rates remain low because people borrow money against these high asset values — this creates even more risk since many of these people are retirees and the HELOCs can often be called/cancelled at anytime by the banks — the wealth they think they have could disappear
- It would seem like banks shouldn’t raise interest rates and the problem would go away, but they don’t have a choice because humans are unfortunately greed-driven and want more — keeping rates low only worsens the problem as people spend and borrow more and more, devaluing the currency more and more and making the country less competitive
- Stocks don’t have monthly payments like mortgages, but the return you earn is typically the benchmark — low returns (normally lower than the S&P500) aren’t acceptable — so they need to chase high returns
- When monthly costs go up, people typically sell real estate — when everyone is selling and nobody is buying, this creates a downward cycle that feeds on itself and worsens the impact of the bubble popping
- When risk-free bond yields go up, investors rush to sell stocks to more the money into safer, higher return assets, causing stock prices to collapse
- Day traders and house flippers worsen the problem, as they encourage higher prices through momentum trading — long term investors get FOMO and the two people with very different goals mix together, fighting for overpriced assets
- Eventually the whole thing cools off, and starts over again
- Nobody knows when bubbles will pop and I am not predicting it — I just use Howard Mark’s notion that I can predict roughly in the cycle where we are -> Prices seem high for low returns therefore it’s a high risk environment
- The value of something is ultimately what someone else will pay for it, but investors want cashflows in the future greater than cashflows now, and in the long run, that is driven by earnings, not speculation
- Speculation and credit causes booms and bust — productivity and increased earnings creates long-term upward momentum
- This video helped me understand a lot of this: https://www.youtube.com/watch?v=PHe0bXAIuk0
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