Famous investors such as Warren Buffett and Hamish Douglass regularly talk to the media about why they believe interest rates are the key driver of whether share markets are good value or not today over the short term.
If interest rates go lower then the returns on risk free debt or cash like securities also go lower, which means the potential growth and yield available from equities becomes more attractive to investors.
In part this is because investors demand less compensation (via lower share prices) for buying risky assets like shares before buying lower risk assets like sovereign paper or money market securities.
Equities are also valued by taking the present value of future cash flows discounted backwards by the assumed risk that those cash flows may not materialise.
The higher the discount rate applied to the future cash flows the lower the net present value of the future cash flows, but as risk free rates fall analysts tend to lower discount rates as debt is cheaper and liquidity more plentiful due to stimulatory policy. In Australia some commentators are even claiming the RBA may be forced into some sort of quantitive easing soon enough where liquidity is literally pumped into the economy by the central bank.
More specifically local cash rate futures traders have been lifting bets all month that the RBA is set to cut cash rates 25 basis points to 0.75% on October 1.
As at September 20 the ASX 30 day cash rates futures contracts were indicating an 82% chance that the RBA will cut next week. On September 11 the odds were just 33% on a cut, with last week’s weak jobs data the catalyst for larger rate cut bets.
In response the local share market is up 0.4% at 6,760 points today and near a record high as investors bid dividend favourites like Sydney Airport Holdings Ltd (ASX: SYD), Transurban Group (ASX: TCL) and Charter Hall Group Ltd (ASX: CHC) higher.
In fact the high valuations of these equities today should be a warning sign to investors as the low yields offer little compensation for the risk being taken on.
As such the ultra-low cash rate environment is inverting the economic orthodoxy in an investment world where bonds are now bought for capital gains and shares for income.
I would not suggest buying shares for income though as it’s fraught with risk if you insufficiently consider the risk of capital losses burying your income.
For example a business like Telstra Corporation Ltd (ASX: TLS) has been forced to slash dividends recently as average revenue per user (ARPU) falls across its product offerings and the NBN leaves a huge profit hole.
I’d only ever buy a stock for income if I were happy to buy it if it didn’t pay a dividend at all, but just bought back shares for example.
The challenge then is to find the right businesses with a few that come to mind being Bapcor Ltd (ASX: BAP), Accent Group Ltd (ASX: AX1), Scentre Group Ltd (ASX: SCG) Washington H. Soul Pattinson Ltd (ASX: SOL) or Sonic Healthcare Ltd (ASX: SHL).
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You can find Tom on Twitter @tommyr345
The Motley Fool Australia owns shares of and has recommended Sydney Airport Holdings Limited, Telstra Limited, Transurban Group, and Washington H. Soul Pattinson and Company Limited. The Motley Fool Australia has recommended Accent Group, Scentre Group, and Sonic Healthcare Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.