If you’re selling stocks because the Fed is raising interest rates, you may have an ‘inflation illusion’

If you’re selling stocks because the Fed is raising interest rates, you may have an ‘inflation illusion’

Forget everything you think you know about the relationship between interest rates and the stock market. Accept the notion that higher interest rates are bad for the stock market, which is almost universally believed on Wall Street. As plausible as this is, it is surprisingly difficult to support empirically.

It would be important to challenge this notion at any time, but especially given the decline in the US market last week following the Fed’s latest interest rate hike announcement.

To illustrate why higher interest rates are not necessarily bad for equities, I compared the predictive power of the following two valuation indicators:

  • The stock market’s earnings yield, which is the inverse of the price/earnings ratio

  • The margin between the stock market earnings yield and the 10-year Treasury yield TMUBMUSD10Y,
    3.748%.
    This margin is sometimes referred to as the “Nutrition Model.”

If higher interest rates were always bad for stocks, the Sustainment Model test would be better than the earnings result.

No, as you can see from the table below. The table reports a statistic called the r-squared, which shows how much one set of data (in this case, the earnings return or the Sustainment Model) predicts changes in a second set (in this case, stock market inflation followed by .-adjusted true result). The table shows the US stock market back to 1871, courtesy of data provided by Yale University finance professor Robert Shiller.

And predicting the actual overall return of the stock market over the other…

The predictive power of stock market earnings returns

The predictive power of the difference between the stock market 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, factoring in interest rates reduces the ability to predict five- and 10-year stock market returns.

Money gambling

These results are so surprising that it is important to investigate why the conventional wisdom is wrong. That wisdom is based on the plausible argument that higher interest rates mean that future years’ corporate earnings must be discounted at a higher rate when calculating their present value. While that argument is not wrong, Richard Warr told me, it is only half the story. Warr is a professor of finance at North Carolina State University.

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. Failure to understand the other half of the story is a fundamental mistake in economics known as the “inflation illusion” — confusing nominal values ​​with real or inflation-adjusted values.

According to research by Warr, the effects of inflation on nominal earnings and the discount rate largely cancel each other out over time. Although earnings tend to rise faster when inflation is higher, they must be discounted more heavily when calculating their present value.

Investors were guilty of inflationary delusion when they responded to the Fed’s latest interest rate announcement by selling stocks.

None of this means the bear market shouldn’t continue, or that equities aren’t overvalued. In fact, by many measures, stocks are still overvalued, despite the much cheaper prices that the bear market enjoys. 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. Its Hulbert Ratings tracks investment newsletters that pay a flat fee to audit. It can be reached at marc@hulbertratings.com

More: Ray Dalio says stocks, bonds to fall more, sees US recession coming in 2023 or 2024

Also read: S&P 500 sees its third leg down more than 10%. Here’s what history shows about past bear markets making new lows from there.

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