Stocks Can Rise Even As Interest Rates Go Up

The first trading day of 2016 got off to a rotten start, as investors worried about many things including, of course, interest rates. In the immediate term, rate worries are understandable. All we’ve heard for 30-plus years is that low rates are great for stocks, so it stands to reason that the reverse must be true – unless it isn’t.

First Things First – A New Regime

For those who aren’t concerned about the prospect of rising interest rates – probably the same as the number of people who’ve never flown and need to pay close attention to what seat belts are and how to fasten them – check Figure 1, the 10-year U.S. Treasury yield from 1/1/62 (yes, that’s ’62, when JFK was still president) through the present.

Figure 1

 

Unless you think Congress and the Administration can come together and agree on a liquidity tax that penalizes savers in such a way as to create the functional equivalent of negative interest rates, your best-case scenario has to be long-term stability, sideways movement, in interest rates. That may happen. But seriously, how often do things ever stay the same?

Nothing ever moves in a straight line, except perhaps, for the work product of a grade-school kid learning to use a ruler to draw on graph paper. So be careful about getting euphoric if and when we see occasional downward moves in rates. The big picture for interest rates is, well, you know. Let’s speak quant. We entered into a new interest-rate “regime.” The last such changeover occurred on 9/30/81, when the 10-year Treasury yield topped out at 15.84%.

What It Means – The View From The Ivory Tower

To decipher the potential impact of rising interest rates, let’s turn to the Dividend Discount Model, the foundational theoretical framework that tells us how stocks are valued. Here it is:

• P = D / (R – G) 
• P = fair Price
• D = Dividend
• R = Required rate of return
• G = expected dividend Growth rate

Please do not try to actually use this formula in the real world. It is just theory (one that among other things, requires an assumed growth rate to infinity). But the idea is important. It shows how one thing relates to another. (For more on how this adapts to the real world, click here.)

Higher interest rates mean that R goes up. And when a positive number in the denominator goes up, the final value of the expression (P) goes down. That’s why falling rates helped stocks for more than 30 years (as R declines, P rises). And that’s why pundits go hysterical when contemplating the prospect of rising rates.

But that view is oversimplified. Stocks are not bonds. The numerator, the stream of cash investors expect, is not fixed. It can rise and it can fall.

This is critical. A substantial portion of the case for higher interest rates is a good economy. And that typically translates to higher earnings (and higher dividends if we want to speak in terms of the model). D is a positive term in the numerator. As it goes up, so, too, does P.

There’s more. Suppose good economic conditions lead us to upwardly revise our expectations for G. As a negative number in the denominator, higher G translates to higher P.

So there we have it. Higher rates can impact stock prices directly or indirectly (through expectations regarding profits, dividends and growth) three ways. One potential impact, increases in R, tends to push stocks down. Two potential impacts, increases in D and G, tend to push stocks up.

So which of these contradictory forces will prevail? That is the magic question. But even if we can’t definitively answer it right now, the fact that we know enough to ask it puts us way ahead of the doctrinaire bears who can’t conceive of anything expect stock-market declines.

Given 30-plus years of the superficial appearance of interest rates being all that matter, and given that to see any other possibility one would have to do some homework (something not terribly consistent with the present culture of instantaneous analysis), it’s easy to envision the bears ruling the day for all or much of the early phase of the new regime we entered. Aggravating the situation, in the short term, may be challenges to profits and growth.

But beyond that, it’s anyone’s game, and one the bulls definitely can win.

A Longer Two-Regime View of History

Given the nature of contemporary databases, it’s not easy to go back to the days before the 9/81 regime got underway. But given that the Fed makes data on the 10-year Treasury available going back to 1/1/62, there are some things we can see.

Figures 2 starts us off with what we know, that a falling-interest-rate regime is good for stocks. (By the way, these S&P 500 prices are adjusted to include the impact of dividends.)

Figure 2: 1981-2015

Figure 3 shows us the obvious contrary phenomenon; that stocks don’t do as well in a rising-interest-rate regime:

Figure 3: 1962-1981

Here’s where one picture can be worth a thousand words. Take another look at the pre-1981 portion of Figure 1. Scary wasn’t it? Now look again at Figure 3.

Yeah, Figure 3 is a great big pile of not-a-whole-lot-of-anything. But, compare it to Figure 1 again. Wouldn’t you have expected Figure 3 to look worse, a heck of a lot worse? Interestingly, the compound average annual return for the entire period was positive, at +2.6%. That’s a lot less than the +9.1% we saw for the 1981-2015 falling-rate regime. But still, the rising-rate-regime result was positive. The S&P 500 had its ups and down but on the whole, it did manage to rise.

We know R, the term in the valuation model that includes interest rates, soared. The fact that P, stock prices, still rose at all confirms that there really is something to the Ivory Tower notions that gains in D and G can offset increases in R.

Figures 4 and 5 show trends in Corporate Profits (in the aggregate, as logged by the U.S. Bureau of Economic Statistics).

Figure 4: 1981-2015

Figure 5: 1962-1981

The compound average annual rates of growth were 7.2% during the falling interest rate regime and 9.1% during the rising interest rate regime.

What About Inflation

All of the numbers used for these graphs are “nominal;” i.e. not adjusted for inflation. It’s reasonable to do this. We typically think of stock prices in nominal terms, so there’s something to be said for keeping things apples to apples. But we still have to be aware of how inflation influenced what we see.

Table 1 shows all the numbers and adds the impact of inflation.

Table 1

Inflation adjusted “real” profit growth was better in the more recent falling-rate regime, but not dramatically so, certainly not enough so to account for the better stock-market performance. The bigger difference was in rates. Table 1 repeats the data in Table 1 but with one important addition, the compound annual rate of change from the 10-year Treasury rate at the start of the period to the rate at the end.

Table 2

Putting It Together

There are many ways one viewing these charts and numbers can interpret the information. Obviously, we see confirmation of there being legitimate grounds for worry. The end of the falling-interest-rate regime removes what had been a huge factor in why stocks advanced as well as they did for most of the past 30-plus years. Superior growth in real “profits” accounted for some of the dramatically better stock gains, but much of it stemmed from the spectacular decline in rates.

Now, for some good news: Look at how horrific the interest-rate experience was during the old regime. Nobody today is forecasting anything close to that, probably because nobody is expecting inflation (a factor in the level of interest rates) to be anywhere near as bad as in the bad old days.

But as bad as rates and inflation were, profits still rose (at a 3.2% annual rate even after subtracting inflation) and stocks still returned a long-term, average of 2.6% per year; not great but a lot better than much of what we’re seeing in the lower-risk portions of the fixed income markets today. If inflation and interest rates can increase at a more measured pace than we saw in the old regime, we may have reason to expect annual equity returns better than 2.6%. How much better (or worse) will depend on “real” profit growth.

That’s what we need to watch; “real” profit growth – not instead of interest rates but together with interest rates, and with every bit the same degree of attentiveness. It won’t be easy. As ever, we have to expect considerable noise. But as time passes, the mega-trends have a way of ultimately wining the day.