by guest author:  Andrew L. Berkin

Berkin begins his analysis of the historical evidence with a review of the theory of the relationship between bond yields and stock returns. He asks: Why might stocks go down when yields rise?

Basic investment theory states that the value of an investment should equal the sum of its discounted future cash flows. Therefore, as interest rates rise, so should the discount rate, which implies that stocks should be worth less. Higher rates also slow the economy, which can dampen earnings and cash flows. Furthermore, higher yields make fixed-income investments more attractive, and equity valuations may suffer.

However, there are also reasons stock returns may be positive in the face of higher yields. Rising rates reflect a robust economy, which should enhance corporate profits and cash flows. In addition, the market already should have priced in expected changes in interest rates and cash flows. Certainly, a rise in bond yields this year would not be an unexpected event.

Berkin concluded: “There are good reasons for both sides of the direction of stocks, and which will win out is hard to say.” The reason is, as Berkin writes, that “equities are influenced by a variety of factors.”

To predict the outcome accurately, an investor would need not only to forecast the future direction of interest rates and their impact on GDP and inflation, but also to forecast accurately how it compares with what other investors already anticipate. That has proven to be an exceptionally difficult task.

Berkin presents U.S. stock returns according to the contemporaneous change in bond yields for a given year, as well as returns according to the direction of the change in yields. His 90 years of data, from 1928 through 2017, split almost evenly between negative (44 years) and positive (46 years) changes in yield.

He found that “whether yields were up or down, stocks did quite well on average. The mean return to the S&P 500 was 10.81% when yields fell and somewhat higher at 12.22% when yields rose. But in both cases there was large variation in returns, as can be seen by standard deviations of almost 20%. Furthermore, minimum and maximum returns were quite extreme whether yields were up or down.”

As a result, Berkin concluded: “There is little evidence that rising rates alone are bad for stocks. … In all cases, stock returns are on average quite strong, although with a high deviation and wide dispersion.”

Even in the quintile of years when rates rose the most, stocks provided, on average, returns of about 9%, not much below their historical average return. However, the single worst return, -43.8%, was in that quintile. On the other hand, the best return in that quintile was almost the same magnitude, at 43.7%.

The information provided is for guidance and informational purposes only.  The articles are not the opinions of ProCore Advisors, LLC.