The Biggest Reason Stocks Are at Record Highs

The Dow Jones Industrials are in line to finish their fifth straight winning year in a row, with gains of almost 23% in 2013 adding to a bull-market run that has sent the Dow up 140% since its 2009 lows. A big economic recovery helped stocks bounce back from their meltdown during the financial crisis, but the biggest factor supporting the bull market is the rock-bottom level of interest rates over the past several years. Following are four ways in which low rates have proven to be the biggest driver of share prices in the Dow and the broader market.

1. Low rates have forced many investors into stocks.
Before the financial crisis, many conservative investors relied on safe investments such as Treasury bonds and FDIC-insured CDs to generate the income they needed for their living expenses. With typical rates on CDs in the 4% to 5% range, many retirees and others who lived off the income from their investment portfolios could generate enough cash to survive at those rates.

Federal Reserve building in Washington, D.C. Source: Flickr Creative Commons (image creator: DonkeyHotey).

The persistent low interest rates from the Federal Reserve over the past five years or so have crushed savers, however, with rates on CDs falling to 1% or less. And although investors bear ultimate responsibility for choosing to raise their risk level to get more income, many have nevertheless felt forced to do so, shifting toward dividend-paying stocks. That phenomenon has pushed high-dividend stocks to high valuations, with Johnson & Johnson and PepsiCo representing just a couple of the many above-average yielding dividend stocks with earnings multiples above 20 in light of huge demand for their shares.

2. Low rates boosted corporate profits because of refinancing.
Corporate earnings have driven the stock market higher, but in large part, companies boost their earnings because of low rates. Countless companies have successfully refinanced outstanding debt over the past several years at rates much lower than what they were paying on their old debt, cutting their interest costs and thereby raising their net income. Although those cost-saving opportunities haven't disappeared entirely, most companies have already gotten most of the mileage they can from refinancing, and so investors can expect one growth driver for corporate profits to fade away if rates start easing upward.

3. Low rates make stocks look more valuable.
Most stock valuation models use discount factors to put values on future streams of income. The lower the interest rate you use, the greater the value of expected profits well into the future. So with record low interest rates in recent years, it's been easy to argue for stock prices that represent much higher earnings multiples than normal.

Unless you expect those interest rates to be permanent, though, relying on them for long-term valuation purposes is dangerous at best. If interest rates start to rise, then the same factor that led analysts to overvalue stocks could make them overreact on the downside, punishing stocks in a much more severe correction than might be warranted under the circumstances.

Ben Bernanke. Source: Federal Reserve.

4. Low rates have made leveraged strategies more profitable.
Largely because of Ben Bernanke's policies at the Fed, rock-bottom short-term rates have made it easy for companies to use leverage to boost their returns. Some companies use leverage at the root of their business models, such as mortgage REITs Annaly Capital and American Capital Agency , and for them, even the hint of rising rates has sent their share prices plunging recently in anticipation that the best rate conditions for those companies might be coming to an end.

More generally, though, companies have taken advantage of low rates to borrow for unusual purposes, such as doing share buybacks or paying dividends to shareholders. When rates rise, those strategies won't work nearly as well, leaving companies with the unappetizing decision of whether to reverse their earlier generosity or accept much higher costs in the future.

All in all, low rates play a huge role in the record run that stocks have made recently. If those rates rise further, it could put the Dow in serious danger of a reversal of some of its big past gains.

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Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter: @DanCaplinger. The Motley Fool recommends and owns shares of Johnson & Johnson and PepsiCo. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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