Opinion: Higher interest rates probably won’t cause this bull market in stocks to end, according to research dating to 1871

2021-10-29 04:54:00

Investors are beginning to worry that interest rates’ steady march higher over the past few months will sabotage the bull market in stocks.

They shouldn’t worry. My analysis of stock market history since 1871 shows that higher rates are not what causes bull markets to end.

This conclusion is certainly contrary to what we’ve always been taught. Higher interest rates reduce the present value of companies’ future earnings, dividends, cash flows and so forth. In addition, higher rates mean that the stock market faces stiffer competition from bonds. On both grounds, you’d expect higher interest rates to be correlated with lower subsequent stock market returns.

But that’s not what emerges from an analysis of the stock market over the past 150 years, courtesy of data from Yale University’s Robert Shiller. A number of other widely followed indicators have far more explanatory ability than interest rates. And the combination of any of the indicators and rates don’t change the story.

Take the price-to-earnings (P/E) ratio. To measure its explanatory ability, I calculated a statistic known as the r-squared, which reflects the degree to which it is able to predict the stock market’s subsequent returns.

When P/E is used to predict the S&P 500’s
SPX
subsequent 10-year inflation-adjusted total return, its r-squared is 24%. That means that 24% of the historical variations in the market’s 10-year returns can be explained by how high or low the P/E is at the beginning of those 10-year periods.

When P/E is combined with the 10-year yield in a simple econometric model, its r-squared is — you guessed it — 24%. Taking interest rates into account adds nothing.

Note carefully that the bull market isn’t given a new lease on life just because interest rates’ recent trend is unlikely to stop it. The P/E ratio is in overvalued territory, after all — higher than 95% of all monthly readings since 1871. So it wouldn’t come as a surprise if the stock market were to produce mediocre returns, or worse, over the next decade.

But if it does, I wouldn’t blame rising interest rates.

Interest rates do matter

Don’t interpret these results to mean that interest rates are irrelevant. To state the obvious, they are incredibly important. It’s just that the relationship between interest rates and the stock market is anything but straightforward.

One reason it is so complicated is that it’s all too easy to overlook the stock market’s ability to hedge inflation. That’s relevant to this discussion because interest rates and inflation are highly correlated. So when interest rates (and, by extension, inflation) rise, investors mistakenly believe stocks’ subsequent nominal returns will decline. But, to the extent that stocks are a good inflation hedge, that won’t be the case.

This helps to explain why my analysis found that nominal interest rates have so little explanatory ability in predicting the stock market’s inflation-adjusted return.

The bottom line? There’s no shortage of things to worry about in the stock market. But I doubt that the recent trend of interest rates is an additional worry, above and beyond those others.

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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