Stock Market: Should We Be Afraid Of Climbing Interest Rates?

(Drivebycuriosity) - Interest rates are rising again. Today the 10-year bond yield pushed above 3.21% for the first time in seven years. As usual stock prices started to fall. The market follows a simple  model: Stock prices (value of the company) reflect the sum of the expected company dividends in the future. But a dollar tomorrow is worth less today. Therefore the market discounts future dividends with an interest rate. Assumed that company X pays a yearly dividend of $100 and the interest rate is 5%, than the present value of the 2019 dividend is $95, of the 2020 dividend is $90,25, of the 2021 dividend is $85,73 and so on. If the interest rates rises to 6% then present values drop to $94,  $88.36, $83,05 and so on. The higher the interest rates, the lower are the present values of the dividends, which define the value of the company.

Higher interest rates imply a bigger discount, meaning a lower stock price, if everything is equal. This is the ceteris paribus analyses (Latin for: with other conditions remaining the same) that every student of economics learns in the first term. But we don´t live in a ceteris paribus world. Instead everything is changing.

History shows that stock prices & interest rates can happily rise together: The Bank of America Merrill Lynch (finance) notices that “the 1950s was a period of higher stock prices and higher US interest rates. The US 10-year yield bottomed near 1.5% in late 1945 and the S&P 500 remained firmly within its secular bull market until yields moved to 5-6% in the mid 1960s. The S&P 500 rallied 460% over this period.”

Interest rates are rising because the US is growing strongly again. The Federal Reserve Bank of Atlanta calculates that the US economy grew 4.1% in the third quarter (frbatlanta). The market had underestimated the growth of the global economy which lead to extremely low interest rates. Interest rates were close to zero because the US economy was almost stagnating and many speculated on a crash of the Chinese economy.  Now the mood is changing and interest rates are responding to the revitalization of the US economy. Higher growth rates are already translating into faster rising corporate earnings and dividends. Company earnings/dividends are also getting tailwinds from the technological progress which creates new markets and raises efficiency & productivity. Therefore the profit gains & dividend hikes will overcompensate the negative effect of the rising interest rates and the stock market rally should continue.