By Rick Waechter, Founder, and Justin May, Portfolio Manager

There’s been plenty of talk about rising interest rates. Much of it has been focused on how rising interest rates lower the price of bonds (short-term pain) but set you up for higher future returns.

Our investors have most of their money in stocks, not bonds. So how do rising interest rates impact stock prices? The two key points to remember:

1. Higher interest rates, on average, will lower the value of stocks. That’s because stock prices are simply the value of future dividends. Higher rates make future dividends worth less in today’s dollars.
2. Dividend yields (calculated as the dividend divided by the stock price) are lower than they have been for decades. That adds risk for stockholders, because a higher-than-ever percentage of a stock’s value is years, or decades, in the future.

We do not believe high-dividend stocks are better than low-dividend stocks. But they do reduce your risk, all else being equal. The major league baseball playoffs are in full swing (pun intended), so we’ll use a baseball analogy. You’re more likely to get on base if you swing for a single (getting more dividends now) than for a home run (accepting a lower dividend now with an expectation of much higher dividends later). When the headwinds pick up (higher interest rates), it is even harder to hit a home run. That doesn’t mean you’re more likely to win the game by trying to hit singles. It just means you’re taking less risk.

A fuller explanation follows.

First, a reminder of what gives a share of stock value.

A stock’s price is nothing more than the value of all future distributions you will receive as a shareholder. Those can be dividends, or they can be the price you receive when you sell. But the selling price is the other side’s buying price – and the buyer bought the stock for the future value of all the dividends. Therefore, the value of a stock is the sum of all dividends you or future owners will receive.

What makes a stock price change? Two factors:

1. The expectation for future dividends, which generally move in line with profits.
2. Interest rates. A dollar in the future is worth less than a dollar today. How much less depends on interest rates. As interest rates increase, the future value goes down.

As the chart below illustrates, dividend yields for stocks are far lower today than they have been historically.