If You’re Selling Stocks Because the Fed Raises Interest Rates, You May Be Suffering From ‘Inflation Illusion’

If You’re Selling Stocks Because the Fed Raises Interest Rates, You May Be Suffering From ‘Inflation Illusion’

Forget everything you think you know about the relationship between interest rates and the stock market. Consider 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 question this idea at any time, but especially in light of the US market’s fall last week following the Fed’s latest rate hike announcement.

To show why higher interest rates aren’t necessarily bad for stocks, I compared the predictive power of the following two valuation metrics:

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

  • The spread between the stock market’s earnings yield and the yield on the 10-year Treasury TMUBMUSD10Y,
    3.719%.
    This margin is sometimes referred to as the “Fed model.”

If higher interest rates were always bad for stocks, then the track record of the Fed model would be superior to that of earnings performance.

It is not, as you can see from the table below. The table reports a statistic known as r-squared, which reflects the extent 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 subsequent stock market inflation-adjusted real return). The table reflects the US stock market since 1871, thanks to data provided by Yale University economics professor Robert Shiller.

In predicting the actual overall performance of the stock market over the next…

Predictive power of stock market earnings performance

Predictive power of the spread between the stock market earnings yield and the 10-year Treasury yield

12 months

1.2%

1.3%

Five years

6.9%

3.9%

10 years

24.0%

11.3%

In other words, the ability to predict five-year and 10-year stock market returns is reduced when interest rates are taken into account.

Money illusion

These results are so surprising that it is important to explore why the conventional wisdom is wrong. This wisdom is based on the eminently 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 this argument is not wrong, Richard Warr told me, it is only half the story. Warr is a professor of economics 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 appreciate this other half of the story is a fundamental error in economics known as the “inflation illusion” – confusing nominal with real or inflation-adjusted values.

According to research conducted by Warr, the effect of inflation 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 the inflation illusion when they reacted to the Fed’s latest interest rate announcement by selling stocks.

None of this is to say that the bear market shouldn’t continue or that stocks aren’t overvalued. Indeed, by many measures, stocks are still overvalued, despite the much cheaper prices brought about by the bear market. The point of this discussion is that higher interest rates are not an additional reason, in addition to the other factors affecting the stock market, why the market should fall.

Mark Hulbert is a regular MarketWatch contributor. Its Hulbert Ratings tracks investment prospectuses that pay a flat fee to be reviewed. It can be reached at mark@hulbertratings.com

More: Ray Dalio says stocks, bonds should fall further, sees US recession in 2023 or 2024

Read also: The S&P 500 sees its third leg down more than 10%. See what history shows about previous bear markets making new lows from there.

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