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In economics, interest 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. You see that clearly with the fluctuating prices of bonds. But the rule applies as well to farmland, oil reserves, stocks, and every other financial asset. – Warren Buffett

These days, people often ask, “Why is the U.S. stock market up when the economy is shrinking?”

Perhaps surprising to most people, the stock market almost always ignores current economic conditions. As columnist Nir Kaissar, writing for Bloomberg, has pointed out, from 1930 to 2019, the correlation between annual changes in real U.S. GDP and annual real returns for the S&P 500 Index was 0.09. In other words, there was no correlation.

So, what does determine the price of stocks? In the short run, it is market sentiment, which is always unpredictable. Over time, however, share prices reflect the economic value of the underlying businesses.

The economic value of each business is simply all of its future profits discounted to today. And for the stock market, it is the weighted average of the economic values of all of its publicly traded businesses. If you find this answer both highly theoretical and based on an unknown future, we agree with you. It is, however, a helpful framework for understanding how stock prices will move over time.

Let’s talk about discounting those future profits, which is where interest rates come in. A $1-million profit earned 10 years from now is worth less than the same amount earned this year. How much less? Well, that depends on how much you can earn, at a risk-free interest rate, over the same period.

When the long-term rate on government bonds is 2 per cent, a business' future earnings are worth almost 50 per cent more than when that rate is 6 per cent. So, long-term interest rates have a major influence on the economic values of businesses and, therefore, their share prices.

When people ask why the market is up, they are often really asking, “Is the market overvalued?” Two common tests for overvaluation or undervaluation are the price-earnings ratio of the market and the ratio of the market’s overall capitalization to GDP. Today, both of these measures, taken alone, point to a relatively expensive stock market.

This is, however, in part because long-term rates are at historic lows. The 10-year U.S. treasury yield is now about 0.7 per cent – well down from even a year ago. More importantly, because of the high level of government debt worldwide, it is unlikely that governments will allow interest rates to move up significantly in the next several years.

It is impossible to know with any degree of precision whether the stock market is overvalued at any point in time. However, on balance, given the likelihood that today’s low rates will remain so for some time, the stock market appears to be within the range of reasonable valuation – albeit with the usual mix of expensive, fairly priced and undervalued stocks.

You can be sure that Mr. Buffett is not spooked by the shrinking economy. He is, instead, taking advantage of short-term volatility to find attractive investments for the long run.

Biff Matthews is chairman and Doug McCutcheon is president of Longview Asset Management Ltd. of Toronto

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