Friday, June 7, 2013

Rising Interest Rates ≠ Falling Stock Prices

Alejandra Grindal from Ned Davis Research (NDR) visited our offices yesterday.

Alejandra is NDR's senior international economist.  She discussed her positive outlook for the global economy, even though recent data has showed some signs of slowing (especially in China). 

Alejandra also reiterated NDR's belief that we are in the early stages of a secular bull market that could take stocks significantly higher in the coming years.

Like many other analysts, however, NDR is bearish on bonds, believing that interest rates will gradually rise over the coming months as central banks gradually reduce their influence in the credit markets.

So, someone asked Alejandra, aren't higher interest rates harmful to stock markets?

Higher interest rates are normally bad news for stocks.  Not only do higher yields make bonds more competitive to riskier stocks, but using a higher discount rate to future earnings normally pulls stock prices lower.

However, in today's super-low interest rate environment, Alejandra believes that we are a long way from being at a point where bonds are competitive to stocks.

In their view, as long as interest rates stay below 5%, stocks prices have considerable room to run.

This is a view shared by others, as a column written by Paul Lim in last Sunday's New York Times noted:

So how much would rates have to climb before investors became seriously worried about stocks? 

If history is any guide, the threshold is around 6 percent. 

Doug Ramsey, chief investment officer at the Leuthold Group, has looked at stock valuations and bond yields going back to 1878. He has found that while there is a relationship between the two, big trouble for the stock market appears to kick in only when 10-year Treasuries are yielding 6 percent or higher. 

Theories abound as to why 6 percent seems the magic number. James W. Paulsen, chief investment strategist at Wells Capital Management, argues that 6 percent is important because it reflects the overall economy’s nominal long-term growth rate. “I can see why you’d get a negative reaction if the cost of capital for the market was above the inherent, sustainable growth rate of the economy,” he said. 

Mr. Ramsey offers a slightly different explanation. He said that for rising bond yields to hurt the stock market, they would have to be viewed by investors as real competition to stocks. Perhaps at 6 percent, he said, bond yields are high enough that “they are truly thought of as potential replacements or substitutes for long-term stock returns.”