Warren Buffett believes interest rates are critical in determining stock valuations.
On Wednesday, the Dow Jones Industrial Average declined by more than 800 points and the S&P fell by 3.3 percent as investors worried about the negative effects from the rising interest rate environment .
“The most important item over time in valuation is obviously interest rates,” Buffett said last year. “If interest rates are destined to be at low levels. … It makes any stream of earnings from investments worth more money. The bogey is always what government bonds yield.”
On Tuesday, the 10-year note yield traded above 3.25 percent hitting its highest level since 2011. The move occurred about a week after Federal Reserve Chairman Jerome Powell said the central bank is a “long way” from getting rates to neutral in an interview with PBS, which pointed to a possible more aggressive path for rate hikes.
The Oracle of Omaha said that when interest rates rise to high levels such as in the early 1980s, it makes higher equity valuation multiples much less attractive. Investors use U.S. government bond yields as their “risk-free” discount rate in financial models to value stock investments.
“Any investment is worth all the cash you’re going to get out between now and judgment day discounted back. The discounting back is affected by whether you choose interests rates like those of Japan or interest rates like those we had in 1982,” he said in 2017. “When we had 15 percent short-term rates in 1982, it was silly to pay 20 times earnings for stocks.”