The Federal Reserve plans to raise interest rates (the federal funds rate) sooner than expected to cool the booming economy. The stock market reacts quickly: the Nasdaq 100 is in correction territory. What can stock market investors expect when interest rates rise?
Interest rates are rising
The super accommodative monetary policy in the event of a pandemic has strongly supported asset prices. Secondary market bond prices rose because new bonds could be issued at lower rates (and therefore lower current yields – see example on how interest rates affect bonds).
Record-low bond yields and massive fiscal stimulus have pushed investors into riskier assets, including equities, which have been a major contributor to the S&P 500’s outperformance in 2020 and 2021.
When there is again an alternative to equities for yield, investors recalculate the equity risk premium. High-flying stock market valuations are discounted. For bonds, expectations of rising interest rates mean primary market investors are getting higher coupons on new issues. This puts pressure on the prices of bonds outstanding in the secondary market which pay less. This is one of the reasons why bond yields are rising. This article has more on interest rates and the economic outlook.
How do stocks behave when interest rates rise?
Historically, when rates go up, it’s actually good for stocks in general. Again, the implications are that rates are rising to slow (not stop) the rate of economic growth. A strong economy can be very good for business.
Analysis by JP Morgan showed that from February 2009, the S&P 500 and the 10-year Treasury bond moved together until the 10-year rose as high as 3.5%, at which point the two diverged. In other words, rising rates can be good for the overall stock market, up to a point. On January 21, the 10-year Treasury note was at 1.75%.
It is important to note that in any economic and market environment, multiple complex narratives are at play. Now this is no different. Additionally, diversified markets sometimes smooth underlying volatility in certain sectors (hence diversification), while other trends, such as post-Covid rising valuations, are more pervasive. Here are some stock market trends to watch as interest rates rise.
By most metrics, valuations have been stretched for a while for the reasons discussed above. The forward price-to-earnings ratio for the S&P 500 is estimated at 20x, one standard deviation above the long-term average of 16.8x. Although the forward price/earnings ratio has been declining for several months, current valuations continue to charge near flat average annual returns over the next five years based on analysis from JP Morgan.
Corrections are a healthy market function to control valuations and prevent asset bubbles. This is part of what is happening now. We’re late. In 2021, the biggest drop in the S&P 500 was 5.1%. Since 1980, the average drop in intra-annual prices has been 14%. Instead, the index hit 70 new all-time highs in 2021.
That said, that doesn’t mean investors should have been sidelined in 2021. While investing at all-time highs may not be pleasant, historically it tends to produce above-average returns. Last year was no exception: the S&P 500 returned nearly 29% dividends reinvested. You can’t time the market, but you can choose how you invest in it.
Growth vs. Value
The market as a whole moves very differently from a single stock or a single sector. The rotation out of growth stocks this year makes sense in the context of rising rates. Growth stocks (dominated by technology) are characterized as companies that trade at higher price/earnings multiples than other stocks, including value. Investors may be willing to accept higher valuations today on future expectations of continued above-average growth. Growth stocks usually don’t pay dividends and sometimes don’t even generate profits.
In low interest rate environments, the “cost” of waiting for future growth to materialize is low. But when rates rise, future growth is discounted to present value and worth less, so investors may not pay as much.
In contrast, value stocks are characterized by established, dividend-paying companies such as financials, consumer discretionary and energy. Value stocks have cheaper P/E ratios than growth stocks and tend to be much more correlated to the US economy/GDP and interest rates (10-year cash).
Year-to-date, growth is down -12.3% while value is down only -3.6%.¹ Historically, value has outperformed growth , but over the past 10 years, growth has done better on an annualized basis. Whether or not this latest rotation lasts, it illustrates the benefits of having exposure to both in your portfolio.
Diversification, my old friend
The purpose of diversification is that, like large-scale market movements, there is no way of knowing when certain sectors, styles or factors will outperform or underperform, for how long and by how much. By holding a diverse mix of asset classes, factors, styles, geographies, etc., chances are that some part of your portfolio will be underperforming at all times. And it’s good.
The goal of diversification is to help improve the likelihood that during downturns the value of your portfolio will not fall as much as a concentrated allocation would. The trade-off is that a mix of diversified assets is unlikely to outperform a concentrated bet in one sector of the market when it happens to be outperforming.
It’s not a magic bullet, however. Correlations between changing asset classes and globalization have further intertwined global financial markets. But there are still ways to position your portfolio for long-term success.
For example, consider the benefits of adding bonds to your portfolio for stability and income (total return). Since 1981, US aggregate bonds have had only four years of negative total returns.
Also consider non-US stocks. Internationally, valuations are not as high as domestically, so yields are also higher. Over the past 20 years, international equities (MSCI EAFE) have outperformed US equities on an annual basis (S&P 500) 45% of the time, although on a cumulative basis the US has performed much better in the during this period. But there have been other rotations in the past that have favored ex-American assets.
If you’re a long-term investor with a diversified portfolio, selling cash will almost certainly be a mistake. That said, don’t wait for market volatility to rebalance your portfolio for you. While we wait the market to continue to increase over time, that does not mean that all the titles in it will.