If you’re selling stocks because the Fed is raising interest rates, you may be suffering from an “inflation illusion.”

Forget everything you think you know about the relationship between interest rates and the stock market. Take the notion that higher interest rates are bad for the stock market, which is almost universally believed on Wall Street. As plausible as this is, it is surprisingly difficult to back up empirically.

It would be important to question this notion at any time, especially given the US market’s decline over the past week following the recent announcement of a rate hike by the US Federal Reserve.

To show why higher interest rates aren’t necessarily bad for stocks, I compared the predictive power of the following two valuation indicators:

  • The stock market’s earnings yield, which is the inverse of the price-to-earnings ratio

  • The spread between the stock market earnings yield and the 10-year government bond yield TMUBMUSD10Y,
    3.714%.
    This margin is sometimes referred to as the “Fed model”.

If higher interest rates were always bad for stocks, then the Fed model’s track record would be better than earnings yield.

This is not the case, as you can see from the table below. The table includes a statistic known as r-squared, which reflects the degree to which one data series (in this case, earnings yield or the Fed model) predicts changes in a second series (in this case, subsequent stock market inflation)-adjusted real return). The table shows the US stock market going back to 1871, courtesy of Robert Shiller, professor of finance at Yale University.

In predicting the real total return of the stock market over the following…

Predictive power of earnings yield in the stock market

Predictive power of the difference between the stock market earnings yield and the 10-year government bond yield

12 months

1.2%

1.3%

5 years

6.9%

3.9%

ten years

24.0%

11.3%

In other words, the ability to predict five- and ten-year stock market returns decreases when interest rates are taken into account.

money illusion

These results are so surprising that it is important to examine why conventional wisdom is wrong. This wisdom is based on the perfectly plausible argument that higher interest rates mean that future years’ corporate earnings must be discounted at a higher rate when calculating their present value. While this argument isn’t wrong, Richard Warr, a professor of finance at North Carolina State University, told me it’s only half the truth.

The other half of this story is that interest rates tend to be higher when inflation is higher, and average nominal incomes tend to rise faster in higher-inflation environments. Not appreciating this other half of history is a fundamental error in economics known as the “inflation illusion”—confusing nominal values ​​with real or inflation-adjusted values.

Corresponding Research conducted by Warr, the impact of inflation on nominal income and the discount rate largely offset each other over time. While incomes tend to grow faster with higher inflation, they must be discounted more when calculating their present value.

Investors were guilty of an inflationary illusion when they reacted to the Fed’s recent interest rate announcement by selling shares.

None of this means that the bear market shouldn’t continue or that stocks aren’t overvalued. In fact, stocks are still overvalued by many measures, despite the much cheaper prices realized by the bear market. The point of this discussion is that higher interest rates are not an additional reason, alongside the other factors affecting the stock market, why the market should fall.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com

More: Ray Dalio says stocks and bonds must fall further if US recession sees 2023 or 2024 come

Also read: S&P 500 sees its third leg down more than 10%. Here’s what history shows about past bear markets that made new lows from there.

https://www.marketwatch.com/story/if-youre-selling-stocks-because-the-fed-is-hiking-interest-rates-you-may-be-suffering-from-inflation-illusion-11663922290?rss=1&siteid=rss If you’re selling stocks because the Fed is raising interest rates, you may be suffering from an “inflation illusion.”

Brian Lowry

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