Why rising interest rates haven’t driven down stock prices

A version of this article first appeared on TKer.co

Market critics and social media commentators will look at one volatile move in what they consider negative, and jump to the conclusion that the stock market is in trouble.

Maybe the market is finally moving as they predicted. Sometimes that happens.

But markets are complex, and will often move in opposite directions.

Consider the recent rally in long-term interest rates. That should be bad news for the stock market, right? That’s not the case.

In a note to clients on Wednesday, Nick Colas, founder of DataTrek Research, challenged the notion that rising rates mean lower stock market prices. From his note: “You’ve probably heard this sequence of statements many times: Long-term interest rates are going up. This means that the present value of future cash flows is going down. Therefore, equity rates should also go down.”

TKer subscribers are no strangers to this idea.

Colas dismissed this oversimplification, flagging two major problems with the absurd argument he just summarized.

“The first is that it doesn’t work in real life,” he wrote.

He pointed to 2015 to 2019, when the 10-year US Treasury note averaged 2.27%. During that time, the S&P 500’s forward price-to-earnings (P/E) ratio was between 15x and 18x earnings.

He then noted that as of Wednesday, the 10-year yield is now at a record high of 4.49%, yet the forward P/E is also at a record high of 21x earnings.

In short, the market did not do what some skeptics might have thought.

But does this mean that the stock market is irrational? No.

“The second reason that earnings and equity ratios move independently comes down to discounted cash flow calculations,” Colas writes.

Rather than cite his work extensively here, I’ll recommend you subscribe to his work and that of his colleague Jessica Rabe at DataTrekResearch.com.

But the takeaway from his analysis is that rising interest rates are bad in theory if you don’t consider income growth.

“If interest rates rise by 2 percent (as they have since 2020) but earnings growth expectations rise by 3 percent, then equity prices actually rise,” he wrote.

A refreshingly simple observation that speaks to a major mistake that some short-sighted market forecasters continue to make. And that error is fixing one variable in a complex formula while holding all other variables constant.

In the real world, all other variables do not change. Over time, many things change. This includes income, which we have seen trend upward for decades.

To postpone 🔭

Whether it’s rising interest rates , a strong dollar , higher tax rates , higher energy prices , declining interest rates , above-average ratings , or a shrinking equity risk premium , investors should be wary of jumping to conclusions after seeing one metric move the wrong way.

To Colas’ point, you’ll often find historical examples of the market doing the opposite of what you might have found.

In addition, the closer you look, the more likely you will find other variables moving in ways that provide a valid reason why stocks are doing what they are doing.

This does not mean that investors and traders are always rational and never wrong. Instead, it’s all just a reminder that markets are complex and deserve analysis that involves more than speculation based on the movement of a single variable.

See last week’s review of macro crosscurrents on Tker.co >

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