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If you’re selling stocks because the Fed is raising interest rates, you may be suffering from ‘inflation illusion’

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Forget everything you think you know about the relationship between interest rates and the stock market. Take the idea that higher interest rates are bad for the stock market, which is almost universally believed on Wall Street. As plausible as this is, it is surprisingly difficult to substantiate it empirically.

It would be important to question this idea at any time, but especially in light of the decline in the US market over the past week following the most recent announcement of the Fed’s rate hike.

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

  • The earnings yield of the stock market, which is the inverse of the price-earnings ratio

  • The margin between the equity market’s earnings return and the 10-year government bond yield
    TMUBMUSD10Y,
    3.771%
    .
    This margin is sometimes referred to as the ‘Fed model’.

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

It is not, as you can see in the table below. The table reports a statistic known as the r-squared, which reflects the extent to which one data series (in this case, 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 up to 1871, courtesy of data from Robert Shiller, a professor of finance at Yale University.

In forecasting the real total return of the stock market over the next…

Predictive power of the stock market earnings return

Predictive power of the difference between stock market earnings and 10-year government bond yields

12 months

1.2%

1.3%

5 years

6.9%

3.9%

10 years

24.0%

11.3%

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In other words, the ability to predict five and ten year returns in the stock market diminishes when interest rates are taken into account.

Money illusion

These results are so surprising that it is important to examine why the conventional wisdom is wrong. That wisdom is based on the very plausible argument that higher interest rates mean that corporate profits of future years must be discounted at a higher rate when calculating their present value. While that argument isn’t wrong, Richard Warr told me, it’s only half the story. Warr is a professor of finance at North Carolina State University.

The other half of this story is that interest rates tend to be higher when inflation is higher, and average nominal profit tends to grow faster in higher inflation environments. Not valuing this other half of the story is a fundamental flaw in economics known as “inflation illusion” – confusing nominal values ​​with real or inflation-adjusted values.

According to research conducted by Warrthe influence of inflation on nominal income and the discount rate largely cancel each other out over time. While gains tend to grow faster when inflation is higher, they must be discounted more heavily when calculating their present value.

Investors engaged in inflation illusion as they responded to the Fed’s latest interest rate announcement by selling stocks.

None of this means that the bear market must not continueor that stocks are not overvalued. Indeed, through many measures, stocks are still overvalued, despite the much cheaper prices caused by the bear market. The point of this discussion is that higher interest rates are not an additional reason, on top of and among the other factors that affect the stock market, why the market should fall.

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Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings keeps investment newsletters that pay a fixed fee to be audited. He can be reached at [email protected]

More: Ray Dalio Says Equities, Bonds Need to Fall Further, US Recession Coming in 2023 or 2024

Also read: S&P 500 sees its third leg drop more than 10%. Here’s what history shows about past bear markets that hit new lows from then on.

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