Ben Carlson recently wrote about the trouble with single-variable analysis in predicting stock market returns, specifically as it relates to the importance of profit growth. He dispelled the myth that high profit growth is necessary for stocks to do well.
I thought this was interesting analysis, and I wanted to test the reality vs the conventional wisdom for another market myth, namely that stocks can’t do well when interest rates are rising.
To that end, I ran the numbers to see how the S&P 500 performed by decade depending on the movement in both the yield on the 10 year treasury note (set by the bond market), and the federal funds rate (set by the Federal Reserve’s FOMC). Here are the results:
Clearly, stocks did pretty well as yields surged in the 1950s and 1960s. They also did well in the 1980s and 1990s when yields fell from very high levels. Of course, they also fared poorly in the decade after the tech bubble collapsed in 2000, even as treasury yields fell further. So, obviously, stocks can, – and have. – done well even as treasury yields climb substantially.
Looking at short-term rates leads to much the same conclusion:
Clearly, just as with treasury yields, stocks have done well in the past when the Fed has hiked short-term rates, and stocks have also fared poorly when short-term rates have declined. Note, this study doesn’t actually cover Fed rate cycles directly. Instead, it is meant to show a longer timeframe to capture a little of the ‘before and after,’ if you will.
Some other factors, of course, that would have influenced stocks during these rate cycles would be the starting valuation and inflation. In other words, the reason for the increase or decrease in yields and rates may matter more than whether they are rising or falling. Here are some data points for starting and ending S&P 500 P/E multiples by decade, as well as overall inflation trends by decade:
The takeaway from these data points is that stocks have a better chance of doing well when expectations are low (that is, when P/Es are low), and also when inflation is in a kind of sweet-spot. Too much inflation drives investors into real assets and out of stocks, while deflationary trends drives investors into government bonds. This sweet-spot between yields and equities is perhaps best illustrated by this graphic from the indispensable JP Morgan guide to the markets:
In sum, just because rates are on the rise, stock returns don’t have to be awful. That’s no guarantee that they won’t be, but, again, your investment decisions shouldn’t be based solely on the direction of yields and rates.
For further reading, see Urban Carmel’s post on Fed rate hikes and stocks from last August:
And EconomPic blog on how stocks have tended to do well as yields on high-quality bonds have risen:
For my S&P 500 calculation in this case, I used a handy S&P 500 return calculator found here.