Misconceptions: Interest Rates and Stock Prices

Baron Funds President, COO and Chairman, Linda Martinson wrote an interesting investor letter with her 2018 commentary, addressing the misconceptions investors have between interest rates (particularly rising interest rates), and their effect on stock prices. Below are excerpts we think should be highlighted given the relative nuance between these two intertwined variables.

“When investors become more uncertain, risk-aversion is exacerbated. Investors seem to focus reactively and emotionally on the downside risk rather than objectively assessing the circumstances. Many tend to look for an immediate fix to remove their uncertainty and, as a result, make rash decisions. This behavior drives market volatility and short-term correlations higher, which is just what we saw happen in December. At the same time, this created attractive investment opportunities for long-term investors.

Under pressure to make a quick decision, many investors default to rules of thumb. For example, “When X goes up, the stock market goes down.” or “When the economy does this, stocks do that.” Wall Street has plenty of these. However, when complex economic issues are reduced to simple statements of correlation, valuable information may be overlooked.

The market is a complicated machine that is driven by a multitude of factors and can behave erratically over short periods of time. While investors like to look for patterns to rationalize market movements, there may not always be a pattern to be found. That is why it is virtually impossible to predict the market with consistency. While most investors understand that the market is driven by multiple factors, in times of turbulence it seems they search for a simple explanation and focus on one or two factors.

One such factor in recent years has been interest rates. After an extended period with low rates, many have been trying to figure out what would happen with their investments as rates increase. Certain asset classes, like traditional bonds, are directly affected by interest rates. The intrinsic value of a bond is calculated as the discounted value of its future payments. The higher the discount (interest rate), the lower the value of the bond. As such, when rates increase, bond prices fall.

For traditional equities, however, the relationship is less straightforward. There is no doubt that interest rates and their changes affect the stock market. After all, many businesses rely on borrowing to fund and grow their activities. Even companies with no debt on their balance sheets can be affected by changing rates, due to the broad impact on the economy. Conventional wisdom dictates that higher interest rates should translate into higher operating costs for companies, thus lower business values and stock prices. Similarly, if we think about the value of a business as the sum of its discounted cash flows, higher rates should lead to lower valuations. While this makes sense, it is not always what happens. The relationship between interest rates and equities is complex, and oversimplifying may lead to misleading advice and negative investment implications.

Interest rates are only one of many factors that move company stock prices. Companies will be impacted differently depending on their idiosyncrasies, industry, competitive landscape, and capital structure, among other things. The overall economic environment may also counter or amplify the effects of rising rates. Interest rates could increase at times of improving economic conditions, as a result of higher capital demand. On the other hand, they could increase due to worsening conditions, like higher inflation. Furthermore, rates may rise when equity valuations are high or low, and valuations are an important factor to consider when investing. Just because rates are rising or falling does not mean you should reactively invest or sell.

Many investors choose the 10-year rate to assess the impact of rate changes on the stock market. The table below shows that the S&P 500 Index generated positive returns in 13 of the 15 rising rate periods since 1954, a remarkable record. Based solely on this data, one could easily conclude that rising rates are good for stocks.

Before rushing to this conclusion, let’s also look at the returns of stocks when rates fell. As shown above, stocks increased in 12 out of 14 declining rate periods – another remarkable record. The only conclusion we can draw from the data in the two tables is that stocks tend to go up regardless of the direction of the 10-Yr Treasury yield.

Over very short periods, like a single day, when the 10-year rate changes significantly, the stock market tends to change significantly too. These changes would more often than not tend to be in the same direction, although there have been multiple instances when the rate moves significantly up or down and stocks move in the opposite direction. While a highly skilled (and lucky) day trader may benefit from this, such information should not be relevant to long-term investors as it pertains to market timing rather than investing.

Clearly, such simplistic analyses between interest rates and stock market movements are inconclusive. We believe higher complexity and other factors are at play.

At Baron, we factor in the potential effects of rates on the stocks we analyze and invest in. However, we believe that for most of the companies on our radar, factors like long-term growth opportunities, sustainable competitive advantages, strong management, and attractive valuations, among others, play a more important role for the prosperity of a business. We do not believe that there is a rule of thumb that is a good substitute for the in-depth research and experience that a skilled active manager can offer. Rules of thumb exist because history rhymes; a skilled active manager realizes that history does not repeat itself and that there are nuances.

Important Note: This material is for informational purposes only and is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy or investment product. The opinions expressed herein are those of the named advisors at the time written.  Actual economic or market events may turn out differently than as presented. © 2019 Madison Wealth Management