By: Reed C. Fraasa, CFP®, AIF®, RLP®
Some investors have asked if stocks make sense in a world where short-term US Treasuries yield north of 5.5%. 1 While a notable relationship exists between high short-term interest rates and stock market returns, it's important to understand that correlation does not imply causation. Here's a breakdown of the dynamics:
Impact of Interest Rates on Stock Prices: Higher interest rates can generally lead to lower stock prices in the short term. This happens because higher rates increase the cost of borrowing for companies, potentially leading to lower profits. Additionally, higher interest rates can make bonds and other fixed-income investments more attractive than stocks, leading to a shift in investor preference.
Discounting Future Cash Flows: Stocks are often valued based on the present value of their future cash flows. When interest rates rise, the discount rate used in these calculations also increases, which can lower the present value of future cash flows and thus reduce stock prices.
Economic Slowdown Concerns: Central banks often implement higher short-term rates to control inflation or cool down an overheating economy. This can lead to concerns about economic slowdowns or recessions, negatively impacting stock market performance over the short term.
Market Sentiment and Investor Behavior: The stock market is influenced by investor sentiment and expectations. If investors anticipate that high interest rates will negatively impact corporate profits or economic growth, this can lead to a sell-off in stocks, temporarily driving prices down.
Historical Data: Empirical evidence shows that periods of rising interest rates have often been associated with subdued or negative stock market returns. However, this is not always the case, as other factors like the overall economic environment, corporate earnings, and geopolitical events also play significant roles.
There is a correlation between high short-term interest rates and lower stock market returns. However, it's essential to consider the broader economic context, the reasons behind the rate changes, and other market dynamics. Investors often need to look at a combination of factors when assessing the impact of interest rates on stock markets.
Investors can take solace in the historical evidence, which suggests that interest rates have not been meaningful predictors of stock returns. In years with above-median interest rates since 1955, during which the average three-month Treasury yield was 6.7%, US stocks returned an average of 12.1%. This is slightly higher than the average return in below-median interest rate years (11.6%), although the averages are statistically indistinguishable 2.
Exhibit 1 below plots annual US stock returns vs. Treasury yields, further emphasizing the lack of a meaningful relation between the two. The level of interest rates is of little help in predicting stock returns. This is perhaps unsurprising when considering interest rates are one of many factors reflected in discount rates for future cash flows.
The long-term investor will do better staying invested through all interest rate cycles and not trying to time the market.
EXHIBIT 1
Annual US stock returns vs. beginning-of-year three-month US Treasury yields, 1955-2022
-Dimensional Fund Advisors
Past performance is no guarantee of future results. Actual results will vary.
In USD. US stocks are represented by the Fama/French Total US Market Research Index, obtained from the data library of Ken French. Treasury yields obtained from FactSet. The Fama/French index represents academic concepts that may be used in portfolio construction and is not available for direct investment or for use as a benchmark. Index returns do not represent actual portfolios or reflect costs and fees associated with an actual investment.
FOOTNOTES
1 "Daily Treasury Par Yield Curve Rates," US Department of the Treasury.
2 The t-statistic for the difference in means is just 0.13. The t-statistic is a statistical quantity commonly used to test whether a sample average reliably differs from a specified value (e.g., zero). Researchers often cite an absolute t-statistic value of at least 2.0 as the threshold for statistical reliability.
The foregoing content reflects the opinions of Highland Financial Advisors, LLC, and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions, or forecasts provided herein will prove to be correct.
Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns.
Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful or that markets will act as they have in the past.
Reed C. Fraasa is a CERTIFIED FINANCIAL PLANNER™ and founder of HIGHLAND Financial Advisors, a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, and investment management. Reed has 30 years of experience as a fiduciary advisor and is the author of The Person is the Plan®, a unique financial planning process. Reed was a frequent guest contributor on PBS Nightly Business Report and has been featured in the New York Times, Wall Street Journal, and Star Ledger newspapers.