Many stock investors wonder: if the Federal Reserve takes away the punch bowl—as some observers think could happen as soon as mid-year—will it be the end of the bull run?
After seven years of the Fed’s ultra-accommodative interest rate policy, consensus thinking suggests that higher interest rates will be bad for stocks. The warning holds some credibility, given the dazzling rise in stocks fueled by the Fed’s zero-interest-rate policy and unprecedented quantitative easing in response to the financial crisis. Take the fuel away, and the train stops, right?
But in reality, it’s difficult to know exactly how, when, and to what degree Fed policies affect macroeconomic variables such as output, employment, and inflation. That’s because, in the words of economist Milton Friedman, the effects come with “long and variable lags.”
Stock investors get nervous waiting to see what happens, so they try to predict based on history.
Lessons From the Past
The correlation between stock returns and interest rate movements can be hard to pin down. Comparing S&P 500 (SPX) returns to the 10-year Treasury yield shows an interesting love/hate relationship with rising rates (figure 1).
On the one hand, stocks love it when rates rise from a low starting point (upper left corner of the graph). On the other hand, stocks hate it when they rise from a high starting point (lower right corner of the graph). This is intuitive, because the data shows that the risk trade-off between the two asset classes is around 5%. At this yield, investors seem to prefer the risk and return of bonds over stocks. In other words: “Wake me up when we’re close to 5%, and maybe we’ll talk about selling stocks.”
I can guess the next question: What about when rates really go up, as in skyrocket higher? History actually shows us that stocks tend to hold their own during rapid interest rate increases. Since 1998, there were 14 periods when the 10-year Treasury yield increased 50 basis points or more.
As figure 2 shows, the SPX total return averaged 8.46% during periods of rapid interest rate increases. Put another way, investors who sold stocks during those periods likely had to find a pretty sweet alternative to make it worthwhile.
Beware of the Consensus
An investor once said that “if it’s obvious, it’s obviously wrong.” This means the market often does the opposite of what the majority expects. A contrarian hears the pundits on television talking about rising interest rates—and then looks for reasons why interest rates will go lower.
How’s that? First, a contrarian realizes the path to significantly higher interest rates is a challenging one, particularly for policy-makers. The last time the Fed hiked rates was in 2006, when GDP growth was in the 4% to 5% range and unemployment was around 5%. Inflation began to creep in because the economy was picking up steam.
Fast-forward to 2014, and the economic picture is quite different for a deliberating Fed. GDP growth is below what some economists had expected for this stage of the recovery, and it’s inconsistent. Toss in a debatable employment and inflation narrative. There’s even slower growth in Europe and Asia.
Second, the precedent for stubbornly low interest rates is already established. Japan, for example, has battled the low interest rate trend for 20 years. Rates in the U.S. today are similar to the mid-1990s in Japan.
The inference is quite simple and convincing. The U.S. is facing many of the same challenges that Japan faced in the mid-’90s. Japanese investors who bet for 20 years that rates would rise were precisely wrong. Everyone expects interest rates to climb higher based on the simple belief that they can’t stay low forever, but history shows they can stay low—or even decline further—for a long time.
Besides, even if higher interest rates were inevitable, betting on the timing is another story.
The Bottom Line
As investors, our job is to manage risk and stay in the game. Long-term investing success is often graded on having a well-diversified portfolio of stocks, bonds, and other asset classes—not on picking tops and bottoms.
Investors with twitchy fingers who may sell stocks in fear of rising interest rates are simultaneously betting on two things. First, that rates are going to rise soon, and second, that stocks will sell off as a result. Or in other words, they’re willing to wager that “this time it’s different.” Is it?
What Can Happen When You Sit Out?
Risk management includes understanding market-timing risk. Learn some long-term strategies for reducing portfolio risk in this short video.