Why higher interest rates aren't bad for stocks

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Why higher interest rates aren't bad for stocks

Forget everything you think you know about the relationship between interest rates and the stock market. There is almost universally believed that higher interest rates are bad for the stock market, and that's why it's widely believed on Wall Street. It is surprisingly hard to support it empirically, as Plausible as this is.

It would be important to challenge this notion at any time, but especially in light of the U.S. market's decline this past week following the Federal Reserve's latest interest-rate hike announcement.

To show why higher interest rates aren't necessarily bad for equities, I compared the predictive power of the following two valuation indicators:

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

It is not as important as you can see from the table below. The data provided by Yale University s finance professor Robert Shiller shows the degree 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 stock market's subsequent inflation-adjusted real return The table shows the U.S. stock market back to 1871.

When taking interest rates into account, the ability to predict the stock market's five and 10 year returns goes down.

The results are so surprising that it is important to explore why conventional wisdom is wrong. That wisdom was based on the eminently plausible argument that higher interest rates mean that future years of corporate earnings must be discounted at a higher rate when calculating their present value. Richard Warr, a finance professor at North Carolina State University, told me that it is only half the story.

Interest rates tend to be higher when inflation is higher, and average nominal earnings tend to grow faster in higher inflation environments. Failing to appreciate this other half of the story is a mistake in the economics known as the inflation illusion - confusing nominal with real, or inflation-adjusted, values.

According to research conducted by Warr, inflation's impact on nominal earnings and the discount rate largely cancel each other out over time. Earnings tend to grow faster when inflation is higher, but they must be more heavily discounted when calculating their present value.

When the Fed released its latest interest rate announcement, investors were guilty of an inflation illusion.

By many measures, stocks are still overvalued, despite the cheaper prices wrought by the bear market. The discussion is that higher interest rates are not an additional reason why the market should fall, above and beyond the other factors that affect the stock market.

Mark Hulbert is a regular contributor to MarketWatch. He can be reached at mark hulbertratings.com

Here is what history shows about bear markets hitting new lows from there.