Do rising interest rates mean trouble for stocks?

Interest rates are on the rise. Normally, this would be considered unfavorable for stocks. But just how worried should you be, and should you continue to add to your stock market portfolio?

by Marvin Appel, PhD, and Brian Hufford, CPA, CFP

Interest rates are on the rise. Normally, this would be considered unfavorable for stocks. But just how worried should you be, and should you continue to add to your stock market portfolio? In this article, we take a long-term historical view of how stocks have fared under different interest rate climates, and suggest a simple rule of thumb on how to use interest rate changes in your investment decisions.

Why interest rates matter

Rising interest rates can put a damper on the stock market. One reason is because higher yields attract investment dollars away from stocks to a greater extent than lower yields. If you expect to net 10 percent per year from stocks, minus any risk involved, a high-quality bond yielding 8 percent might appear to offer a better balance of risk vs. reward. The same bond yielding 6 percent would be less tempting, so you would be less likely to sell off stocks to buy bonds.

Second, for many companies interest payments represent a significant expense. Lower rates may mean lower borrowing costs, which would result in better corporate profits. All else being equal, the higher the earnings for each share of stock, the more the stock should be worth.

How can rates rise before the Fed acts?

This type of increase applies to long-term bond rates, such as the yield on 10-year Treasury notes. Supply vs. demand for bonds typically determines the long-term rate. The Federal Reserve has direct influence over shorter-term rates only. Even in the face of the Fed's action to lower short-term rates, more people currently are eager to borrow relative to the supply of investors willing to lend, so rates are rising.

Some analysts interpret rising long-term interest rates as a sign that inflation, or accelerated economic growth, will soon be on the rise. Since the bond market does not have a single collective opinion, it is difficult to ascertain. What is clear is that the supply/demand balance for bonds is pushing rates higher.

How can I tell if rates are rising or falling?

In terms of their effect on the stock market, a successful technique has been to compare current rates to those six months previous. If 10-year Treasury note yields are higher than they were six months ago, rates are rising - a historically bad sign for stocks. If 10-year yields are lower now than they were six months earlier, stocks historically have performed better than average.

According to the Federal Reserve news release of March 25, 2002, the trend in interest rates has turned upwards. As long as this condition persists, stocks will - at the least - be facing a headwind.

The difference interest rate changes have made

We studied the S&P 500 Index from July, 1962-March, 2002.* During the entire period, the S&P 500 rose at a rate of 7.5 percent per year, compounded. Interest rates were falling only 45 percent of the time during this 40-year period.

An investor in the S&P 500 during this time - when rates were falling - would have earned 6.6 percent per year. In other words, an investor in the market less than half the time would have captured 88 percent of the profits. When out of the market, an investor theoretically could have collected interest by investing in low-risk Treasury bills, short-term bank accounts, or (when available) money market funds.

To put this another way, when interest rates were falling, the market gained 6.6 percent per year. When rates were rising, the gains were only 0.9 percent per year.

Even though the market has earned little during periods of rising rates, risk has been significant. The 1973 to 1974 bear market and the 1987 crash both occurred in the setting of rising interest rates.

Does this always work?

Unfortunately, no stock market indicator always works, and, of course, no level of future performance can be guaranteed based on past results for any investment strategy.

In the second half of the 1990s, the stock market did not follow its usual patterns relative to interest rates. In 1998, both interest rates and the market fell together. During that time, the fear was deflation, which never materialized. Since World War II, inflation - not deflation - has been the norm.

From 1995 to 1998, the market rose strongly, even during periods of rising interest rates. The market also rose in 1999 - again as interest rates started to rise. The following year gave back its gains before the interest rate trend again turned favorable. The recent bear market saw its final stage during periods of falling interest rates.

Implications

The strategy described here is only one of a number of possible interest rate indicators and is not intended as a stand-alone market-timing tool. Even so, market risk has to be considered higher now that Treasury note yields have turned up. Investors should be wary of high-volatility stocks or mutual funds.

Current and historical information on 10-year Treasury note yields is available on the Federal Reserve Web site: www.federalreserve.gov/releases/H15/data.htm.

•The S&P 500 represents stocks in 500 large, U.S. companies. Dividend payments or transaction costs are not included here. This study is entirely hypothetical, as individual investors would not have had access to a low-cost index investment during much of the study period.

Stock market data are as of the last trading day of each month, while interest rate data represent conditions that applied in bond markets two to three weeks earlier. As a result, a hypothetical investor would have had the opportunity to obtain the interest rate information before acting.

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