Interest rates acts on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull. So if the government rate rises, the prices of all other investments must adjust downward. Conversely, if government interest rates fall, the move pushes the prices of all other investments upward. Consequently, every time the risk-free rate moves by one basis point–by 0.01%–the value of every investment in the country changes.
The power of interest rates had the effect of pushing up equities as well, though other things that we will get to pushed additionally. To achieve juicy profits in the market over long-term say 10 or 17 or 20 years, one or more of three things must happen:
(1) Interest rates must fall further- If government interest rates were to fall to half, then that factor alone would come close to doubling the value of common stocks.
(2) Corporate profitability in relation to GDP must rise – The inescapable fact is that the value of an asset, whatever its character, cannot over the long term grow faster than its earnings do. This is a critical fact often ignored–that investors as a whole cannot get anything out of their businesses except what the businesses earn.
GDP and its effect on Profit
When government talks about GDP growing 2%, keep in mind that the population grows 1%. It’s GDP per capita that counts. And GDP counts people who make you take off your shoes before you get on a plane. It counts goods and services that we wish we didn’t want. When you get into a war, if you drop planes into the ocean, it [building replacement planes] is part of GDP.
The quality of GDP isn’t talked about very much. I don’t see how corporate profits will move up as percentage of GDP. BRK Annual Meeting 2003 and 2004
(3) Just pick the obvious winners