There is no simple relationship between interest rates and the stock market. In particular, a lower interest rate doesn’t necessarily lead to a higher stock market and a higher interest rate doesn’t necessarily lead to a lower stock market.
The conventional wisdom on this topic is based largely on what happened over the past few decades. Clearly, US equities generally fared well after interest rates embarked on a long-term downward trend in the early 1980s and generally fared poorly when interest rates were in a rising trend during the 10-14 year period prior to the early 1980s. Also, the inverse relationship (a lower interest rate leads to a higher stock market and a higher interest rate leads to a lower stock market) seemed to make sense and was incorporated into a popular stock market valuation tool called “The Fed Model”.
The Fed Model compares the earnings yield of the S&P500 Index (the reciprocal of the S&P500′s P/E ratio, expressed as a percentage) with the 10-year T-Note yield to determine if the stock market is over-valued or under-valued. The higher the S&P500 yield relative to the 10-year T-Note yield, the better the value supposedly offered by the stock market. An implication is that if the 10-year yield is very low, the S&P500 can have a very high P/E ratio and still not be over-valued. For example, according to the Fed Model the S&P500 is attractively valued today. This is because even though the current P/E ratio is almost as high as it ever gets (excluding the 1999-2000 bubble period), the current earnings yield is well above the current 10-year T-Note yield.
However, the simple relationship between interest rates and the stock market only makes sense at a superficial level. It doesn’t hold up under deeper analysis. The reason is that the current value of a company is the sum of all of that company’s future cash flows discounted at some rate, and in most cases it will not be appropriate to use today’s interest rate to discount cash flows that won’t happen until many years or even decades into the future.
When picking a rate at which to discount distant cash flows it would be more reasonable to use a long-term average interest rate than to use the current interest rate. Furthermore, there is no good reason why the change in the interest rate over the next 12 months should significantly affect the interest rate used to discount cash flows that are expected to occur 10-20 years into the future.
But if it is wrong to assume that the stock market should trend inversely to the interest rate over long periods, then why did this assumption prove to be correct over the bulk of the past 50 years?
The first part of the answer is that over the very long term the stock market swings from under-valued to over-valued and back again and that in the early 1980s a bond market under-valuation extreme happened to coincide with a stock market under-valuation extreme. The second part of the answer is that financial market history goes back much further than 50 years and the simple relationship on which the Fed Model is based is not apparent prior to 1970. In essence, the theory that a lower interest rate leads to a higher stock market and a higher interest rate leads to a lower stock market is an artifact of the past 50 years.
The above statement is supported by the following charts. The charts show the Dow Industrials Index and the 10-year T-Note yield from the beginning of 1925 through to the end of 1968.
The US stock market (as represented by the Dow Industrials in this case) was in a secular bearish trend from 1929 until 1942. Apart from an upward spike due to fear of government default in 1931, the 10-year yield was in a downward trend during this bearish stock market period. The stock market then embarked on a secular bullish trend that didn’t end until the late-1960s. The 10-year yield was in an upward trend during this bullish stock market period. That is, the long-term relationship between interest rates and the stock market during 1929-1968 was the opposite of what it was over the past 50 years.
About Steven Saville
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