Why rising interest rates haven’t crushed stock valuations

A version of this article first appeared on TKer.co

Market skeptics and commentators on social media will watch a single variable move in a way they consider unfavorable and then conclude that the stock market is in trouble.

Maybe the market will eventually move as they predicted. Sometimes that happens.

But markets are complicated and often move in counterintuitive ways.

Consider the recent spike in long-term interest rates. Must be bad news for the stock market, right? Not necessarily.

In his note to clients on Wednesday, Nick Colas, co-founder of DataTrek Research, disputed the idea that rising rates automatically mean lower stock market valuations. From their note: “You’ve probably heard this sequence of statements many times: Long-term interest rates are rising. This means that the present value of future cash flows is declining. Therefore, stock valuations should fall as well.”

TKer subscribers are no strangers to this theory.

Colas dismantled this oversimplification and pointed out two big problems with the shoddy argument he just summarized.

“The first is that it doesn’t work in real life,” he wrote.

He pointed to the period from 2015 to 2019, when the 10-year US Treasury bond yielded an average of 2.27%. During that period, the S&P 500’s forward price-to-earnings (P/E) ratio was between 15 and 18 times earnings.

He then noted that as of Wednesday, the 10-year yield is now much higher, at 4.49%, and yet the forward P/E is also much higher, at 21 times earnings.

In short, the market did not do what some skeptics might have assumed.

But does this mean that the stock market is irrational? No.

“The second reason stock returns and valuations move independently comes down to the math of discounted cash flow,” Colas wrote.

Rather than citing too much of his work here, I’ll recommend that you sign up to see the work of him and his colleague Jessica Rabe at DataTrekResearch.com.

But the bottom line from their analysis is that rising interest rates are theoretically bad for valuations if you don’t account for earnings growth.

“If interest rates rise 2 percentage points (as they have since 2020) but earnings growth expectations rise 3 percent, then stock valuations actually rise,” he wrote.

It’s such a refreshing and simple observation that it speaks to a huge mistake that some short-sighted market forecasters keep making. And that mistake is adjusting one variable in a complex formula while keeping all other variables constant.

In the real world, all other variables are never constant. With the passage of time many things change. This includes profits, which we have seen trending upward for decades.

Walking away 🔭

Whether it’s rising interest rates, a stronger dollar, higher tax rates, elevated energy prices, lower odds of rate cuts, above-average valuations, or a shrinking equity risk premium, investors should be careful not to jump to conclusions after seeing a single metric move unfavorably.

From what Colas says, you will often find historical examples of the market doing the opposite of what you might have intuited.

Furthermore, the closer you look, the more likely you will find other variables moving in ways that provide a theoretically sound justification for why the stock does what it does.

This is not to say that investors and traders are always rational and never make mistakes. Rather, it’s all just a reminder that markets are complicated and deserve analysis that involves more than a guess based on the movement of a variable.

See last week’s review of macro countercurrents on Tker.co >

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