Will Stocks Fall as Interest Rates Rise?
There is a common misconception that a falling bond market is good for the stock market. The reasoning goes as follows: Bonds are a safe-haven asset whereas stocks are “risk-on” asset. If money is coming out of bonds that means that people no longer wish to hold safe-haven assets, and they therefore want riskier assets — stocks. Furthermore, many investors think in a binary asset environment — you can own either stocks or bonds — and if money is coming out of bonds then it will flow into stocks.
The negative correlation between stocks and bonds — U. S. Treasury bonds in particular — is the exception, not the norm. However the exceptional case is a big deal and it must be understood. If we seen a deflationary spike such as the one we had back in the Fall of 2008 or the one we saw during the 1929 stock market crash or the 1931 European banking crisis, then this negative correlation will play out.
Investors will seek out safe-haven assets such as Treasury bonds in a financial crisis, but there is no fundamental reason for this. Government bonds are riskier in a downturn because they are backed by tax revenues, and a slower economy means fewer tax revenues. In 1929 and in the early 1930s the U. S. government’s debt load was very small relative to tax collections and relative to what it is today, and so bonds really were a safe haven. Furthermore, back then the U. S. Dollar was backed by gold, and so U. S. Government debt was, in effect, a future claim on America’s gold.
With respect to the deflationary spike in 2008 the story is a little different. People bought Treasuries because they were seen as zero-risk assets. Ultimately, with the Federal Reserve’s unlimited ability to purchase government bonds, there is virtually no fear of a default. But notice that during that crash we saw corporate bonds fall alongside stocks, and this speaks to my point that bonds and stocks are positively, not negatively correlated.
Why are bonds and stocks correlated? Simply put stocks have value insofar as they can return capital to shareholders, and this is a function of a company’s earnings or its cash-flow. While we look at metrics such as a company’s price to earnings ratio we can, in fact, invert this figure to measure its earnings yield (e.g., a stock that trades at 10-times earnings has a 10 percent earnings yield).
As bond prices fall this means that investors are demanding a higher yield on their investments. This isn’t exclusive to bonds — it also applies to stocks. So if bonds trade lower so that their aggregate yield rises by 2 percent (say, from 3 percent to 5 percent), then a stock that has an earnings yield of 5 percent (a P/E ratio of 20) in the 3 percent market environment is going to trade lower so that its earnings yield reflects the higher interest rate environment.
If the yield difference remains at 2 percent then we will see the company’s shares trade with an earnings yield of 7 percent after bond prices adjust. This will bring its P/E ratio down to 14.3, which means that the stock has to fall 28 percent in order to reflect this new interest rate environment. Even if the company’s earnings are growing, the stock will almost certainly fall as it would have to increase its earnings by a hefty 40 percent in order to trade with the same price but still reflect the higher interest rate environment.
While short term shocks to the market such as the financial crisis of 2008 may distort this fundamental reality somewhat we will generally see stock prices positively correlated to bond prices.
The assets that become more valuable, then, are those assets that have intrinsic value that doesn’t come from their cash-flow potential: commodities. If we look at prolonged bear markets in stocks and bonds such as the one we had during the 1970s, the best performing assets turn out to be commodities.
This is true to a large extent in the 21st century. While stocks — as measured by the S&P 500 — are nominally higher than they were since peaking in early 2000 the returns have been minimal except in specific companies. From December 31, 1999, through today the S&P 500 is up a paltry 27 percent. If you had just held commodities, however, you would have done extremely well.
Oil, copper, gold, soybeans, and several other commodities have increased in value by hundreds of percentage points that make the gains seen in the S&P 500 appear to be negligible. Furthermore, considering that we need to consume these commodities to survive, the cost of living has risen substantially more than the stock market, and in this respect stocks have been in a de facto bear market for a long time.
There will always be stocks that perform well no matter what environment. There were stocks that rose in 2008 such as McDonalds (NYSE:MCD) and Wal-Mart Stores (NYSE:WMT); Emergent Biosolutions (NYSE:EBS) soared from $5 per share to $25 per share in 2008. So long as there are technological innovations, mineral discoveries, and niche companies there will be rising stocks no matter what the S&P 500. But broadly speaking, as interest rates rise investors will demand higher earnings yields from their stocks, and they will trade lower in the aggregate.
Disclosure: Ben Kramer-Miller has no positions in any of the stocks mentioned.