Larry Swedroe turns to a new study from Andrew Berkin, his colleague and co-author, on the long-term link between equity prices and bond yields.
As the director of research for Buckingham Strategic Wealth and The BAM Alliance, one of the most-asked questions I’ve gotten lately involves the impact of rising interest rates on equity prices, with the conventional wisdom among many seeming to be that increasing rates are bad for stocks.
The specter of rising interest rates aside, it’s not as if investors don’t already have enough to worry about, with U.S. equity valuations at historically very high levels (the Shiller CAPE 10 ratio, as I write this, is above 32), the potential threat of a trade war, the risk of Italy leaving the euro, as well as other geopolitical risks, including North Korea, Iran and Syria.
With a strong economy, investors are becoming even more worried about rising interest rates and the effect they could have on equity (and bond) valuations. So what, if anything, should investors do with their equity portfolios in response to rising rate risk? As always, to answer that question, I’ll turn to academic evidence and financial theory, rather than some guru’s opinions.
Perhaps the most important thing is not to confuse knowledge with value-added information. Let me explain.
In investing, there is a major difference between information and knowledge. Information is a fact, data or an opinion held by someone. Knowledge, on the other hand, is information that is of value.
In this instance, the information is that the Federal Reserve is expected to increase interest rates perhaps two more times in 2018. That leads many investors to conclude they should minimize equity risk, as equities compete with bonds. Thus, rising rates would no longer be supportive of today’s historically high valuations.
Of course, this ignores the lesson the market taught in 2017, as the Fed raised rates three times last year, yet the S&P 500 returned almost 22%. With that in mind, let’s turn to a review of the longer-term evidence on the link between stock prices and bond yields. Thanks to Andrew Berkin, the director of research at Bridgeway Capital Management and the co-author of two of my books, “The Incredible Shrinking Alpha” and “Your Complete Guide to Factor-Based Investing,” for his study, “What Happens to Stocks When Interest Rates Rise?”, which appears in the Summer 2018 issue of The Journal of Investing.
Rising Rates Study
Berkin begins his analysis of the historical evidence with a review of the theory of the relationship between bond yields and stock returns. He asks: Why might stocks go down when yields rise?
Basic investment theory states that the value of an investment should equal the sum of its discounted future cash flows. Therefore, as interest rates rise, so should the discount rate, which implies that stocks should be worth less. Higher rates also slow the economy, which can dampen earnings and cash flows. Furthermore, higher yields make fixed-income investments more attractive, and equity valuations may suffer.
However, there are also reasons stock returns may be positive in the face of higher yields. Rising rates reflect a robust economy, which should enhance corporate profits and cash flows. In addition, the market already should have priced in expected changes in interest rates and cash flows. Certainly, a rise in bond yields this year would not be an unexpected event.
Berkin concluded: “There are good reasons for both sides of the direction of stocks, and which will win out is hard to say.” The reason is, as Berkin writes, that “equities are influenced by a variety of factors.”
To predict the outcome accurately, an investor would need not only to forecast the future direction of interest rates and their impact on GDP and inflation, but also to forecast accurately how it compares with what other investors already anticipate. That has proven to be an exceptionally difficult task.
Berkin presents U.S. stock returns according to the contemporaneous change in bond yields for a given year, as well as returns according to the direction of the change in yields. His 90 years of data, from 1928 through 2017, split almost evenly between negative (44 years) and positive (46 years) changes in yield.
He found that “whether yields were up or down, stocks did quite well on average. The mean return to the S&P 500 was 10.81% when yields fell and somewhat higher at 12.22% when yields rose. But in both cases there was large variation in returns, as can be seen by standard deviations of almost 20%. Furthermore, minimum and maximum returns were quite extreme whether yields were up or down.”
As a result, Berkin concluded: “There is little evidence that rising rates alone are bad for stocks. … In all cases, stock returns are on average quite strong, although with a high deviation and wide dispersion.”
Even in the quintile of years when rates rose the most, stocks provided, on average, returns of about 9%, not much below their historical average return. However, the single worst return, -43.8%, was in that quintile. On the other hand, the best return in that quintile was almost the same magnitude, at 43.7%.
Given that the results above are for returns in the same year as yield changes, Berkin examined whether perhaps there is a delayed reaction, where the impact of a rise in rates hits stocks later. He writes: “Such an effect would be good to know, because an investor would be able to look at a change in rates this year and make decisions about prospective returns next year.”
Here, Berkin found “some evidence that stocks do better when rates fall. When yields move lower equities returned 13.31% on average in the next year, compared to 7.55% in the year after rates rose.” When evaluating by the magnitude of yield change, stock returns are highest, at 14.17%, in the year after rates fell the most.
This is notably higher than stock returns when rate changes are in the upper two quintiles. However, he writes, “a crucial point is that stock returns are nicely positive in all cases.”
Because long-term bond yields are only one way to measure interest rates, Berkin also examined the relationship between equity returns and the level or change of short-term Treasury bills, the spread between long- and short-term yields, and real (inflation-adjusted) yields. Again, he found no significant relationships. In addition, looking at longer-term stock returns of three, five and 10 years also showed no effect.
Berkin also examined the data from international markets. Once again, he found similar results. With data from the mid-1980s for 22 developed markets, he found that whether rates rise or fall, stock returns are still quite positive on average, though, as was the case in the U.S., there is great dispersion in returns.
Interestingly, the international markets have done quite well when yields rise the most, returning on average 13.3% annually—well above the roughly 6% earned in the second and third return quintiles.
As he did with U.S. stocks, Berkin examined international equity returns in the year after a change in rates. Returns are notably weaker although still decently positive when yields rise, at 4.80% annually, compared to a 16.15% return when yields fall. When yields rose the most, equity returns are weaker yet, at just 1.42%, which offers some evidence that equity performance is relatively weaker when rates rise a lot. In contrast, returns are quite strong when yields fell the most or when yields fell into the next quintile of moderate declines.
Berkin then looked at various sectors of the market to see how they performed when yields rose. Because many investors use high-dividend-paying stocks as a substitute for safe bonds, he examined the relationship of such equities to interest rates. Defining high-dividend stocks as the top 30% of stocks that pay dividends, Berkin found that they outperform nicely when interest rates fall, but lag modestly (0.19%) when rates rise.
As Berkin writes, “when rates rose the most, high dividend stocks had a 4.20% shortfall relative to the market in that same year.” He concluded: “For investors in high dividend yielding stocks, the upshot is to be wary of an increase in interest rates. While results can vary by a lot, on average returns are weak when rates rise. But for those who can hang on to these stocks, they have tended to subsequently recover.”
Berkin also looked at small-cap stocks versus large-cap stocks and found that when long bond yields fall, smaller-cap stocks have lower returns that same year. This runs contrary to logic that dictates higher rates should hurt small stocks. Furthermore, no distinct pattern emerges in the year after bond rates change. There is also no clear trend in the same year that short-term rates change.
However, small-cap stocks do lag in the year following a sharp rise in short-term rates. Thus, while there is some evidence yield changes impact smaller-cap stocks, results are quite mixed and often do not conform to the logic that has been given.
Berkin also examined other styles of investing used in asset pricing models—specifically, value, momentum, profitability and quality stocks. He found “none of these factors showed any distinguishing pattern with interest rates. Thus it is quite difficult to make the case that a change in yield has an effect on these factors and the market segments they represent.”
Finally, Berkin looked at sector returns. He concluded: “Returns are independent of interest rates. Two possible exceptions are utilities and durables. Utilities have low returns in years when bond yields rise the most, but this tends to revert in the next year. Such behavior is similar to what is seen for high dividend payers, which utilities tend to be. Durables also have weak returns in years when short term rates rise the most, and they get even weaker the following year. This may be an effect of higher borrowing costs for a capital intensive sector or possibly just random noise given the number of different sectors and scenarios considered. … While the popular press has many stories about which sectors will do well or poorly when rates move, there is little evidence.”
While there has been much worry about the effects of rising interest rates, such concerns seem to be misplaced. First, to have an impact, rates not only have to rise, they have to rise more than the market already expects. Keep in mind the market is still expecting at least one, if not two, more rate hikes by the Fed this year. If there are more hikes, it’s likely they will be the result of the Fed seeing stronger-than-expected economic growth (which is good for stocks).
The bottom line is that, even if you could be certain interest rates would rise, the evidence demonstrates it would be hard to profit from that information by shifting your equity allocation ahead of time.
This commentary originally appeared June 13 on ETF.com
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