Are Higher Interest Rates Bad For Stocks?

Question: Are higher interest rates bad for stock prices?

The conventional wisdom says yes, but the opposite case can be made as well. As a famous lawyer once said, “I can argue it both ways”.

As an economy, the US is on the cusp of exiting its worst deflationary period since the Great Depression. In the post WW II period, the three great wealth creation vehicles were:

A.) small business creation;

B.) common stocks (via long-term investing) and;

C.) real estate, both residential and commercial;

Starting with March, 2000 and the bursting of the technology and the large-cap growth bubbles, and then spectacularly with the 2008 recession, two of those three wealth vehicles came crashing to earth.

Today, with the S&P 500 making new all-time highs, and residential real estate in a bona fide recovery, the average American with a home and a 401(k) is starting to feel like risk-taking, hard work, savings and investment actually might pay off.

The constant cacophony around interest rates is puzzling and deafening. This is just a personal opinion, but given the PCE (Personal Consumption Expenditure) data, and the spread between the yield on the 10-year Treasury TIPS, and the 10-year Treasury, the “true” inflation rate is probably around 1.5%. (The Treasury TIPS curve now looks to be inverted with the 10-Year TIPS yielding at negative 60 basis points. I’m not sure what that is telling us other than inflation continues to “deflate” or disinflation continues.)

Given that the historical “real return of return” on Treasuries is 2% over the period dating back to the 1970s, the 10-year Treasury yield SHOULD eventually trade between 3.5% - 4%.

Stock prices will adjust to these higher yields, with the stock market impact depending on the speed of the “mean reversion” to 3.5% – 4%.

If we get to 3% by Labor Day, the S&P 500 will likely be down hard. If the Treasury vigilantes adjust Treasury yields at a measured and slower pace in advance of the Fed, the S&P 500 should continue to make new highs.

While everybody is now talking “1994″ in terms of the historical pattern, a more frightening period was early in 1987. Remember, the pro-growth policies of the Reagan Adminstration, and the falling interest rates from the 15% high in 1980, not to mention the collapse in crude oil to per barrel in 1986 to $10 per barrel, drove a huge boost in economic growth in during the 1984 – 1986 period. However, in early 1987, crude oil started to rise, and the dollar started to weaken measurably, resulting in a horrid rise in Treasury yields throughout 1987.

From January to early October, 1987 the 30-year Treasury yield rose from 7% to close to 10%. The 10-year Treasury yield rose from 7% to over 9% over the same time period.

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Between March and May 1987 alone, the 30 year Treasury yield rose from the low of 7% to 8.5%, accouting for the majority of the move. (For those old enough to remember, Merrill Lynch supposedly lost an obscene amount of money in March 1987, as one of their mortgage traders threw a ticket in a drawer and forgot about it. The amount I remember is $300 ml, but I cant verify that. I think the trader is still around too.)

We all know what happened in October, 1987, too. Interest rates rose for a long time before the equity markets corrected, and the S&P 500 tripled from 120 to 380 between August, 1982 and early October, 1987.

Still, the US economy today is more similar to 1990 – 1993, than the mid-1980′s. Fiscal policy is a huge drag on the monetary stimulus.

High interest rates are on their way: faster economic growth would be a huge positive, as would even a bit of inflation. However too much of both (at too fast a rate) isn’t a good thing.

Don't obsess about interest rates, but do obsess about the rate of that change: that is the key.

I had lunch with Jeff Miller of upgrades of Facebook from SPCapital IQ and another firm. Pay attention to the revisions in revenue estimates. (Long FB)

The high-yield ETFs look interesting: the iShares iBoxx Dollar High Yield Corporate Bond Fund (HYG) and the SPDR Barclays High Yield Bond ETF (JNK) had a tough week, down 2%.

Portfolio strategy: we manage all individual clients money via separate accounts at Charles Schwab (SCHW), which is a stock we are long. We thought we’d add a section to feature our longer and short-term strategies for client portfolios:

Secular:
Overweight equities: prefer US large-cap given the valuation, which gives clients international exposuire as well. Overweight equities given the standard 60% / 40% asset allocation.

Underweight duration: like everybody else, I think interest rates have nowhere to go but up.

Don’t own any gold, and think the dollar will strengthen gradually for a while, at least the next few years.

Tactical:
Equity: overweight technology and financials. Slowly positioning portfolios for a “return to global growth” scenario, which includes industrials / cyclicals.

Fixed-income: the ProShares Short 20+ Year Treasury Fund (TBF) (unlevered inverse Treasury ETF) is now one of our largest positions, given the 10-year yield traded above 2.09%. We are overweight credit risk too, given the slowly improving US economy. The high-yield ETF’s had a tough week, this past week, down 2%. We think high-yield still works in terms of a tactical allocation. May add to high yield this coming week.

Summary: the S&P 500 is still about 2% above its 50-day moving average and is only in the earliest stages of being “oversold”. S&P 500 earnings are actually fine, and face easier comp’s as we move through 2013. Bullish stock market sentiment per Bespoke plunged this week, despite a pretty modest correction in the markets, which tells you volumes about how current individual investors are viewing the current equity market rally.

A pullback in the S&P 500 to 1,600 or the October ’07 high of 1,575 would be perfect.

Written By: Brian Gilmartin