Interest Rate “Gravity” Could Bring Stocks Back Down to Earth

By Chris Lowe, Editor-at-Large on July 7, 2014

Janet Yellen better hope she can keep a lid on interest rates.

As Warren Buffett has pointed out:

[I]nterest rates act as gravity behaves in the physical world. At all times, in all markets, in all parts of the world, the tiniest change in rates changes the value of every financial asset. […] If interest rates are, say, 13%, the present value of a dollar that you’re going to receive in the future from an investment is not nearly as high as the present value of a dollar if rates are 4%.

What Buffett means is that stock market pros don’t value stocks in a vacuum. Instead, they try to figure out what stocks are worth relative to what interest they could earn with theoretically lower risk in the bond market.

When you boil it down, investing is all about putting up money today for the hope of more money in return sometime in the future.

And that’s why interest rates matter.

For example, if you invest $100 in company shares you’re costing yourself the interest you could earn on that money in the bond market. The higher the interest available in the bond market the higher the opportunity cost to you of investing in stocks.

This is called the time value of money. And it means $1 in the future will be worth less to you than $1 today.

That’s why if interest rates are at 13%, the present value of a dollar you are going to receive in the future from an investment is not nearly as high as it would be if interest rates were at 4%.

This is why Yellen better hope that interest rates stay low. Because as they rise so does the rate of return investors can get in the bond market. This pushes down the present value of every dollar of cash payments investors hope to receive in the stock market.

As you can see from the chart below of long-term interest rates, going back to 1790, long-term interest rates are at historic lows… meaning that any asset priced off of this rate is at risk.

Source: The Big Picture

That’s why we continue to encourage readers to remain cautious when it comes to the US stock market. Not only is it overvalued, also it’s vulnerable to a rise in interest rates.

As Braden Copeland, who edits our newest investment advisory service, Building Wealth, puts it, that means staying long stocks if you’re already long… but making sure you have stop losses in places to protect your downside.

P.S. Don’t forget to check out Braden’s report on how to protect your profits before the next crash comes. Braden not only details exactly what to do right now to make sure you don’t lose your shirt in the next downturn, he also names six “bulletproof” stocks to buy when everyone else is panicking. You can find Braden’s full report here.

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