John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.
The consensus continues to be that the Federal Reserve will start raising U.S. interest rates in September, and that has many equity investors feeling uneasy. Rising rates, the theory goes, spell trouble for stocks.
Or do they?
The research shows the issue to be far more complex than many believe. On one hand, some studies indicate rising rates are indeed trouble. In their book Invest With the Fed, Robert Johnson, Gerald Jensen and Luis Garcia-Feijoo found that, while stocks typically aren't crushed when rates rise, they've averaged just 0.8-per-cent after-inflation annualized returns during rising-rate periods since 1966, according to The Wall Street Journal.
But another researcher, Javier Estrada of the IESE Business School in Barcelona, has found that there is no consistent historical relationship between interest rates and the stock market, MarketWatch reported in 2013. (Professor Estrada also found that the so-called "Fed Model" – the idea that equities should command higher P/E ratios when rates are low, and vice versa – is likely based on coincidence rather than reality.)
Further muddying the waters, in any given period involving rising rates, stock returns have varied wildly. In a 2013 piece for Financial Advisor magazine, Rob Brown looked at S&P 500 returns during 12-month periods in economic expansions when interest rates rose the most. (As a proxy for interest rates, he used the 10-year Treasury yield.) To get an idea of how different the results can be, we need look no further than the three most recent rising-rate periods on his list.
In the 12-month stretch ended May 31, 2004, the S&P jumped 18.3 per cent; in the 12 months ended Oct. 31, 1994, gains were a much more moderate 3.9 per cent; and in the 12 months ended May 31, 1984, the results were flat-out poor, with the S&P losing 3.1 per cent.
This lack of consistency is partly a result of all interest-rate hikes not being created equal. A one-percentage-point increase is more meaningful if your starting point is 1.5 per cent as opposed to 6 per cent. It's also extremely hard to isolate the impact of rate increases. A rate rise may be a drag on stocks, but if rates are rising because the economy is strengthening, investors may see that as a net positive. And that's an incredibly simplistic example. So many factors influence stocks that it's nearly impossible to say that performance is directly attributable first and foremost to a particular rate change.
That being said, when rates do rise, they will be rising from extremely low levels. That's significant, according to Doug Ramsey of the Leuthold Group. Mr. Ramsey's research (which goes back to 1878) shows that, while bond yields (which are usually linked to rates) do affect equity valuations, stocks don't seem to run into big trouble until 10-year Treasury yields hit 6 per cent, according to The New York Times. That's when bonds "are truly thought of as potential replacements or substitutes for long-term stock returns," Mr. Ramsey says. Currently, we're nowhere near 6-per-cent Treasuries.
That makes sense. But alas, the market never makes things too neat and tidy – there have been plenty of times when rates rose off very low levels and stocks did poorly, just as there have been plenty of times when already-high rates rose even higher, and stocks jumped.
In the 12 months ending Jan. 31, 1980, for example, stocks rose more than 20 per cent, according to Brown, even though benchmark rates were rising off a double-digit starting point. In the 12 months ending July 31, 1957, meanwhile, stocks returned less than 1 per cent amid rate hikes that brought the effective Federal Funds rate to a still-low 3.25 per cent.
Another current problem for prognosticators: Rates are usually increased to cool off an overheating economy, but in the current situation, the increases would simply be a normalizing process following a financial crisis.
A bullish takeaway?
When it comes to ascertaining how interest-rate hikes could affect today's market, all that seems clear to me is that there is no clarity. And that reinforces my belief that investing systematically and not letting macroeconomic factors sway you is the best approach. Even if we had a clear answer as to how rate hikes affect equities, it wouldn't do us much good because so many other factors are at work in the market. Interest rates could be giving a clear, unequivocal bullish or bearish signal, and that signal would be one of dozens, perhaps hundreds directing stocks.
This, of course, is at odds with what you hear from many pundits who say rate hikes are certain doom for stocks. That's a good thing. The more talk about rate increases derailing the bull market, the more stable becomes the "Wall of Worry" that keeps equity prices from getting too bloated, which is good for bull runs.
I'm not saying interest-rate increases won't hurt the market this time around. But history shows it's far from a slam-dunk case – and there's certainly not enough evidence for me to alter my long-term approach. My advice: Stay disciplined, focus on undervalued stocks of solid companies and leave the rate-hike guessing game to others.