I have mentioned previously that extremely low interest rates make stocks more valuable. Some readers have asked me to explain further. Consider the following simple example.
Annette wants to invest $100,000 for a 10-year time frame. She is considering 10-year Government of Canada bonds or RBC common stock. The bond is just about as "safe" as can be in terms of assured return. But, as of today, that return is only a paltry 0.6% or $600 annually. Ignoring any reinvestment and compounding, total 10-year interest received would be 6.0% or $6,000. Including return of principal, Annette would receive a total of $106,000 from the bond.
The return potential of stocks is much greater than bonds but, of course, stocks involve a number of risks. Assuming a price per share of $100, Annette could buy 1000 shares of RBC for $100,000 (plus a few dollars in commission if she has an online brokerage account). RBC is currently paying quarterly dividends of $1.08 per share for an annual total of $4.32 per share. If RBC continues to pay dividends at this rate, Annette would receive $4,320 annually which would add up to $43,200 over ten years (assuming no reinvestment and ignoring compounding). If Annette sells the RBC stock ten years from now and the price is still $100 per share, her total return would be $143,200. But, of course, unlike interest on the Government of Canada bonds, there is no guarantee RBC will continue to pay dividends at that rate and there is no guaranteed future stock price (companies which experience sustained earnings declines or losses may cut or suspend dividends).
But consider this. Assuming dividends are maintained at the same rate, an investment in RBC stock would match the total return of the bond if the RBC share price is just $62.80 in 10 years ($43,200 in dividends plus $62,800 in sale proceeds for a total of $106,000). So, in this scenario, anything better than a $62.80 RBC stock price produces a return greater than Government of Canada bonds. Even in the face of the current elevated uncertainty, that is a pretty big cushion 10 years out.
Do not get me wrong. I am not suggesting you dump all your bonds and buy stocks. Despite terrible rates, bonds provide safety that you just can't get with stocks. But I hope this example illustrates why very low interest rates can push stock prices higher.
A couple of other notes:
Keep an eye out for my next email which provide details on an upcoming Webinar during which I will talk about the current environment and answer your questions.
I will be appearing at the online MONEYSHOW CANADA EXPO on Thursday November 5 at 4:40pm ET. There will be other speakers with a variety of perspectives some of which you may wish to check out. Click here to see more and register for free.
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