The Threat And Risk Of Rising Interest Rates: Separating Fact From Fiction

Johnson & Johnson (NYSE:JNJ)

Although the factors that drive returns and affect stock valuations are interesting and useful to evaluate by looking at the overall market, I believe they are more pertinent when evaluating individual stocks. The following P/E ratio versus interest rates graph on Johnson & Johnson (NYSE:JNJ) illustrates a similar relationship of falling stock valuations in conjunction with declining interest rates. As I will illustrate next, high valuation was once again the headwind that defied logic.

Just as we saw with the S&P 500, Johnson & Johnson (NYSE:JNJ) was also overvalued in 2000 and stayed that way until 2007. However, the big difference between Johnson & Johnson and the S&P 500 is that Johnson & Johnson’s earnings grew much more consistently over this historical timeframe. It is important to note that Johnson & Johnson’s stock price reverted to the mean of fair value (touched the orange line) in the early spring of 2007 and then became undervalued in 2009.

In economic theory they have an important qualifying phrase “Ceteris Paribas” which loosely translates to all things being equal. What this suggests is that economic theory will typically work as planned as long as all other factors are within normal ranges. Consequently, when you examine the P/E ratio versus interest rates graph on Johnson & Johnson (NYSE:JNJ) since the beginning of 2009, you discover that the theory of the inverse relationship is intact. As interest rates continued to fall, the P/E ratio of Johnson & Johnson -and with it its stock price – increased in contrast. All was well with the universe once again.

When we review the earnings and price relationship of Johnson & Johnson over this same timeframe, additional insights are revealed. Here we might be safe in assuming that interest rates played a role in Johnson & Johnson (NYSE:JNJ)’s increasing P/E multiple. On the other hand, we cannot deny the role that undervaluation coupled with steadily increasing earnings (and dividend growth) played. Interest rates are an important factor, but they are just one among many important factors that drive stock prices.