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

(Drivebycuriosity) - Finally we got the correction many were praying for.  Dow Jones & S&P 500 dropped each 10% below their all-time highs, the first correction since February 2016! Many pundits claim that the recent drop was caused by rising interest rates. In the recent days the long term interest rates (10 year US government bonds) hit a four-year high of 2.88%. It seems that the 30-years trend of declining interest rates has come to an end.

John Cochrane, owner of the influential blog "The Grumpy Economist", relates the stock market gains since 1990 with the decline of the interest rates in the same period (johnhcochrane). Below you can see the cumulative return (stock market gains plus dividends) of the New York Stock Exchange since 1990 and the interest rates for 10 year US government bonds.

Many expect that the interest rates have hit the bottom and might begin to a rise again. How would that bode for the stock market?

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.”

Below you can see charts for the Dow Jones since the year 1900 and for stock prices since the 15th century (history). These charts show that stock prices have been going up over the time - independent from interest rates. It seems that interest rates don`t matter in the long run.

I don`t say that interest rates don´t matter in a short period and I am aware that interest rate gyrations can cause stock market swings. This can be explained with 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.

Interest rates are rising because the market is getting less pessimistic. The market had underestimated the future 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 seems to change and interest rates are responding to the stronger growth of the global economy (Europe, China & India) and the revitalization of the US economy. The market is adapting to the perception that cutting US company taxes will boost the growth rate of the US GDP which will translate into higher interest rates, 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 may overcompensate the negative effect of the rising interest rates and the stock market rally should continue.