Forget everything you think you know about the relationship between interest rates and the stock market. Take the notion that higher interest rates are bad for the stock market, which is almost universally believed on Wall Street. Plausible as this is, it is surprisingly difficult to support it empirically.
It would be important to challenge this notion at any time, but especially in light of the U.S. marketās decline this past week following the Federal Reserveās most recent interest-rate hike announcement.
To show why higher interest rates arenāt necessarily bad for equities, I compared the predictive power of the following two valuation indicators:
- The stock marketās earnings yield, which is the inverse of the price/earnings ratio
-
The margin between the stock marketās earnings yield and the 10-year Treasury yield
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3.715% .
This margin sometimes is referred to as the āFed Model.ā
If higher interest rates were always bad for stocks, then the Fed Modelās track record would be superior to that of the earnings yield.
It is not, as you can see from the table below. The table reports a statistic known as the r-squared, which reflects the degree to which one data series (in this case, the earnings yield or the Fed Model) predicts changes in a second series (in this case, the stock marketās subsequent inflation-adjusted real return). The table reflects the U.S. stock market back to 1871, courtesy of data provided by Yale Universityās finance professor Robert Shiller.
When predicting the stock marketās real total return over the subsequentā¦ | Predictive power of the stock marketās earnings yield | Predictive power of the difference between the stock marketās earnings 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, the ability to predict the stock marketās five- and 10-year returns goes down when taking interest rates into account.
Money illusion
These results are so surprising that itās important to explore why the conventional wisdom is wrong. That wisdom is based on the eminently plausible argument that higher interest rates mean that future yearsā corporate earnings must be discounted at a higher rate when calculating their present value. While that argument is not wrong, Richard Warr, a finance professor at North Carolina State University, told me, itās only half the story.
The other half of this story is that interest rates tend to be higher when inflation is higher, and average nominal earnings tend to grow faster in higher-inflation environments. Failing to appreciate this other half of the story is a fundamental mistake in economics known as āinflation illusionā ā confusing nominal with real, or inflation-adjusted, values.
According to research conducted by Warr, inflationās impact on nominal earnings and the discount rate largely cancel each other out over time. While earnings tend to grow faster when inflation is higher, they must be more heavily discounted when calculating their present value.
Investors were guilty of inflation illusion when they reacted to the Fedās latest interest rate announcement by selling stocks.Ā
None of this means that the bear market shouldnāt continue, or that equities arenāt overvalued. Indeed, by many measures, stocks are still overvalued, despite the much cheaper prices wrought by the bear market. The point of this discussion is that higher interest rates are not an additional reason, above and beyond the other factors affecting the stock market, why the market should fall.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com
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