Should Equity Investors Fear Rising Rates?
“Interest rates are going to rise … and rising rates are always bad for stocks.” – XYZ Pundit
Rising rates are bad for stocks – fact or fiction?
Despite what you may have heard from XYZ Pundit on financial TV, the relationship between interest rates and stock market returns is not exactly cut-and-dried. (Side note: when someone uses the phrase “always” in markets, you can be sure they are full of it.)
Since 1928, the correlation between the annual change in the 10-year U.S. Treasury yield and the S&P 500’s total return is effectively 0 (.02). In plain English this means that in any given year, interest rates rise or fall without any predictive value over stock market performance.
The 10-year U.S. Treasury yield has risen in 46 calendar years since 1928. The S&P 500’s total return in those years? 10.5% annualized and up 78% of the time.
Some of the best years in stock market history (1928, 1933, 1950, 1955, 1958, 1975, and 2013) have occurred in years when interest rates rose. And to be fair, because they are uncorrelated, some of the worst years in history also featured rising rates (1931, 1937, 1941, 1966, 1973, and 1974).
What about when interest rates have fallen in a given year? How have stocks fared? The S&P 500 has had an 8.4% annualized return with 67% of years positive. You’ll note that these numbers are slightly lower than the rising rate years, which is to say that historically the greater fear for a rational investor should actually have been falling, not rising, interest rates.
Indeed, in recent history that has been more often the case, with the two worst years (2008 [-36.6% S&P 500] and 2002 [-22% S&P 500]) occurring when the 10-year yield fell 1.81% and 1.23% respectively. That is not to say that stocks haven’t had great years when rates have fallen. They have. Some of the best years in history have occurred in years of falling rates (1935, 1936, 1945, 1954, 1985, 1989, 1991, 1995, and 1997). But falling rates is neither a requirement for nor a guarantee of positive stock market returns.
Confused yet? Good, you should be, for is it not easy to reconcile the idea that stock market returns can be positive on average in both rising and falling interest rate periods. It is also not intuitive, given the importance of interest rates and how frequently their direction is discussed, that one could not anticipate the direction of stock prices even if they predicted correctly where interest rates were going.
And predicting that direction is no easy task, as we have seen time and again in recent years when calls by supposed “experts” for “rising rates” have not materialized. But even if they did materialize it would not be enough to forecast stock prices; you would also have to predict why they were going there.
Let me explain.
Rising interest rates coupled with a recession and inflationary concerns (1973, 1974) can indeed be a difficult environment for stocks. On the other and, rising interest rates associated with economic expansion and higher growth prospects (2003, 2009, 2013) can be a favorable backdrop. Similarly, falling interest rates coupled with recession and deflationary concerns (2008, 2002) are indeed very bad for stocks. However, falling interest rates in a low inflation but not outright deflationary environment can be quite good (1995, 1997) for stocks.
Will interest rates rise or fall over the next year and why will they be rising or falling? I don’t know.
Given the difficulty in predicting not only interest rates but also their impact on stocks, why then do we waste so much time listening to pundits and their prophesies on such topics? Because most of the day-to-day market action is noise, but saying as much goes against the business model of entertaining viewers with bold forecasts and calls. And most people seem to prefer entertainment over analysis.
Far better to put on a pundit who speaks with conviction and hyperbole about something he knows nothing about than to put on a professional who speaks with reservation and evidence about how difficult this forecasting game really is.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
CHARLIE BILELLO, CMT
Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.
Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.
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