Forget everything you thought you knew about the relationship between interest rates and the stock market. Take the notion that high interest rates are bad for the stock market, which is almost universally believed on Wall Street. While this is plausible, it is surprisingly difficult to support it empirically.
It’s important to challenge this idea at any time, but especially in light of the U.S. market’s decline last week following the Federal Reserve’s latest interest rate hike announcement.
To illustrate why higher interest rates are not bad for stocks, I compared the predictive power of the following two valuation indicators:
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The stock market’s earnings yield, which is the inverse of the price/earnings ratio.
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The spread between the stock market yield and the 10-year Treasury yield TMUBMUSD10Y;
3.712% .
This margin is sometimes referred to as the “federal model”.
If higher interest rates are always bad for stocks, the Fed’s model track record will outpace earnings gains.
Not as you can see from the table below. The table reports a statistic known as r-squared, which shows the degree to which one data series (in this case, the earnings results or the Fed model) predicts changes in the second series (in this case, the stock market’s continued inflation). – adjusted real return). The table is It reflects the U.S. stock market in 1871, according to data provided by Yale University finance professor Robert Shiller.
| When predicting the total return of the stock market next… | The predictive power of the stock market’s earnings yield | The predictive power of the difference between the stock market yield and the 10-year Treasury yield |
|
12 months |
1.2% |
1.3% |
|
5 years |
6.9% |
3.9% |
|
10 years |
24.0% |
11.3% |
In other words, factoring in interest rates reduces the stock market’s ability to predict five- and 10-year returns.
Money nightmare.
These results are so surprising that it is important to examine why the conventional wisdom is wrong. That wisdom is based on the highly persuasive argument that high interest rates mean that future corporate earnings must be heavily discounted when calculating their present value. While that argument isn’t wrong, Richard Warr, a finance professor at North Carolina State University, told me it’s only half the story.
The other half of this story is that interest rates tend to be higher when inflation is high, and average nominal income grows faster in high-inflation areas. Failure to appreciate this half of the story is a fundamental error known in economics as “inflation” – the difference between nominal and real or inflation-adjusted values.
Research by Warr shows that the effects of inflation on nominal income and the discount rate cancel each other out over time. While incomes tend to grow faster when inflation is high, they must be discounted significantly when calculating their present value.
Investors were guilty of inflation in response to the Fed’s latest interest rate announcement by selling stocks.
None of this means that the bear market should not continue or that stocks will not be overvalued. Indeed, by many measures, despite many cheap prices in a bear market, stocks are still overvalued. The main point of this discussion is that higher interest rates are not an additional reason, more than other factors that affect the stock market, why the market falls.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay for audits. He can be reached mark@hulbertratings.com
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