Record low rates redefine value stocks for investors

Indeed, if analysts such as Jonathan Wilmot from Credit Suisse are right this period of low interest rates could go on for as long as 25 years.

He has taken a forensic look at two other historical periods that have the most in common with what is happening now.

They are the global recession of the 1890s and the Great Depression of the 1930s.

The key lesson from those torrid times was that interest rates stayed low for as long as 25 years from the start of the crisis.

For sure economies have changed in all sorts of ways since then but Wilmot highlighted the similarities in key metrics such as unemployment, industrial production, corporate earnings and credit issuance.

If he's right then it won't be the first time in economic history when interest rates stay low for a long period.

Record low interest rates and bond yields are often cited by equity bulls as a reason why the sharemarket can rise.

If bond yields are low it can sometimes make certain shares look cheap on certain measures of valuations.

But it can be a trap. If bond yields are low because inflation is falling, and it's tipped to fall further, then forecasts for nominal GDP growth should also drop.

And given that profits should rise in line with GDP over the long run, then forecasts for profit growth must be downgraded at some point.

And that should spell bad news for shares.

The same can be said if bond yields fall because of fears about the pace of real GDP growth.

Slow economic growth is not great for profits but these record low interest rates, which are low because there is no growth, can help valuations in other ways.

Indeed, as Bell points out, low interest rates, rather than the US economy growing, has been the major reason why the S&P500 has almost tripled in value over the past seven years.

The rise in McDonald's is a good example of how and why shares have done well but is also a signal to be wary of any further gains.

Anyone who snapped up shares in McDonald's seven years ago has done quite well.

The share price has appreciated by 90 per cent since then which is a 9.6 per cent per annum return.

Not bad at all.

Even better when investors consider that revenue in those seven years, between 2008 and 2015, rose by less than 1 per cent per year and net income by even less.

"The balance sheet was more dynamic: property and equipment rose 14 per cent, but long-term debt rose by over 135 per cent. Its shareholders' equity contracted by close to 50 per cent," said Murray Stahl of Horizon Kinetics.

As he says if you were told all of that in 2008, would you, or should you, have bought shares in McDonalds?

Probably not.

But the shares have headed higher as its P/E ratio expanded from 16.4 times to 24.6 times.

Bell explains that because shareholders were willing to pay much more for the same earnings the stocks headed higher. In the end that accounted for about half of the total return from the stock.

The other thing that helped was the fall in the yield of the key US Treasury bond.

During those seven years it fell from just over 4 per cent in 2008 to around 2.30 per cent at the end of 2015. It has fallen further this year to 1.77 per cent.

"This permitted McDonald's to finance a massive share repurchase program that would have been unaffordable but for these artificially low rates, which is why its interest expense only rose by 22 per cent even as its debt ballooned by over six times this amount," said Stahl.

Buybacks in the S&P500 have contributed to 25 per cent of any EPS growth since the first quarter of 2012, but over the past four months the number of repurchases announced has dropped 38 per cent.

Investors are worried about what happens when companies stop buying their stock.