Equity Valuation

Below is the equation used to calculate the market value to help to show you the factors influencing it. A stock market price is the present value of the company’s future earnings and then divided by the discount rate plus equity risk premium. In laymen terms, it Is the price you are willing to pay today, assuming that the price will grow in line with the future earnings at the discount rate. The discount rate will usually refer to the yield on the government bond so this is the part of the equation being directly influenced by negative rates.


Currently, at the moment you have multiple countries around the world with negative interest rates but how is that affecting the performance of their stock markets. The short answer is not well. Currently, at the moment we are in a seven-year bull market since the financial collapse in 2008 which has been mainly due to loose monetary policy but has the latest monetary trick of negative interest rates helped this. Looking at the stock market returns alone, the answer is no.

Currently, around the world, we have 5 regions in negative rates – Japan, Switzerland, Denmark, Sweden and some of the Eurozone. One of the main aims of ZIRP (zero interest rate policy) is to push investor away from the standard safe haven assets such as government bonds and into riskier assets. Another aim is to try to stop people and banks saving cash and to spend it in the market. Below you can see those results on their retrospective exchanges.

The Eurozone was the only area to see a positive performance of their stock market after the move to negative rates but that shortly faded away. But before we jump the gun let’s have a look what factors do affect the markets.

When the discount rate moves to 0% or below and the equity risk premium stays the same the price of the stock should in theory rise. This is what was seen after the financial crisis when the government reduced the market rate which gave an instant boost to stock prices.

So why is this not happening with the local stock markets when rates are reduced further and put into negative territory? We will have to look at the rest of the equation.

The Equity Risk Premium can be thought of as the compensation for placing the funds into higher risk products (equities) over a safe product such as treasury bills. If the ERP decreases this should lead to an increase in the value of the market and if it increases, it would lead to a fall in the value of the market. Due to the decrease in rates, it has led to either a flat or slightly increased ERP.

The last part of the equation that would affect the market value is the Future Earnings. If future earnings increase the market goes up and vice versa. If the future earnings are dropping at a faster rate than the central banks are cutting interest rates this will lead to a decrease in the stock market which is what we have been seeing in places such as Japan and Europe.

In fact, if you look at the trends previously, the macro environments tend to have a larger impact on the stock market over the long run than changes in interest rates.

Summary

One of the main drivers in the prices of the stock markets recently has been the loose monetary policy but we are coming to a point where further monetary policy will not produce growth. Price increases will only be able to come from improving economic conditions and earnings growth.

negative interest rates and how they affect the market