If you're selling stocks because the Federal Reserve is raising interest rates, you may be suffering from an 'inflation illusion'

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

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

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

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

  • The spread between the stock market yield and the 10-year Treasury yield
    TMUBMUSD10Y,
    3.750%
    .
    This margin is sometimes called the “Federal Reserve model.”

If higher interest rates were always bad for stocks, then the results of the Fed’s model would be better than those of earnings yields.

It is not, as you can see from the table below. The table reports a statistic known as r-squared, which reflects the extent 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 trailing inflation-adjusted real return ). The table traces the US stock market back to 1871, thanks to data provided by Yale University finance professor Robert Shiller.

When you forecast the real total return of the stock market over the next…

Predictive power of stock market returns

Predictive power of the spread between the stock market yield and the 10-year Treasury yield

12 months

1.2%

1.3%

Five years

6.9%

3.9%

Ten years

24.0%

11.3%

In other words, the ability to predict five- and 10-year stock market returns 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. This wisdom is based on the eminently plausible argument that higher interest rates mean that corporate profits for future years must be discounted at a higher rate when calculating their present value. While this argument isn’t wrong, Richard Warr told me, it’s only half the story. Ware 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 incomes tend to grow faster in higher inflation environments. The failure to appreciate this other half of the story is a fundamental error in economics known as the “inflation illusion” – confusing nominal with real or inflation-adjusted values.

According to research conducted by Warr, the effects of inflation on nominal earnings and the discount rate largely offset each other over time. Although earnings tend to grow faster when inflation is higher, they must be more heavily discounted when calculating their present value.

Investors were guilty of the inflation illusion when they reacted to the Fed’s latest interest rate announcement by selling stocks.

None of this means that the bear market must not continue, or that the stock is not overvalued. Indeed, by many measures, the stock is still overvalued, despite much lower prices brought on by the bear market. The point of this discussion is that higher interest rates are not an additional reason, above and beyond other factors affecting the stock market, why the market should fall.

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

More ▼: Ray Dalio says stocks, bonds still to fall, sees US recession in 2023 or 2024.

Read also: The S&P 500 sees its third leg down more than 10%. Here’s what history shows about past bear markets hitting new lows from there.

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