A version of this article first appeared on TKer.co. Market skeptics and social media commentators often notice a single volatile movement that they view as unfavorable and jump to the conclusion that the stock market is in jeopardy. It’s possible that the market will eventually align with their predictions—sometimes that occurs. However, markets are intricate, and they frequently move in unexpected ways.
Take the recent increase in long-term interest rates. This would seem bad for the stock market, right? Not necessarily. Stock prices can still rise even as interest rates increase, as noted by Fred. In a note to clients on Wednesday, Nick Colas, co-founder of DataTrek Research, challenged the assumption that higher interest rates automatically lead to lower stock market valuations. He pointed out, “You’ve probably heard this line many times. Long-term interest rates are rising. This means the present value of future cash flows is falling. Therefore, stock valuations should fall as well.”
Not all TKer subscribers may be familiar with this theory. Colas dissects this oversimplification, highlighting two major flaws in the argument. “First, it doesn’t work in real life,” he writes, referencing the period from 2015 to 2019 when the 10-year Treasury yield averaged 2.27%. During this time, the S&P 500’s forward price/earnings (P/E) ratio ranged from 15 to 18 times. More recently, as of Wednesday, the 10-year Treasury yield had risen to 4.49%, yet the forward P/E ratio was also significantly higher at 21 times. Essentially, the market did not act in line with some skeptics’ expectations.
But does this imply that the stock market is irrational? Not necessarily. Colas explains, “The second reason why yields and stock valuations move independently comes down to discounted cash flow calculations.” Instead of elaborating on this, I suggest checking out his and colleague Jessica Rabe’s work at DataTrekResearch.com.
The key takeaway from his analysis is that while rising interest rates might theoretically hurt valuations, this can change if revenue growth comes into play. “If interest rates rise 2% but earnings growth expectations increase by 3% (as they have since 2020), stock valuations will actually rise,” Colas notes. This simple observation illustrates the significant error some short-sighted market forecasters make by altering one variable while assuming others remain constant.
In reality, variables are never static; many aspects evolve over time, including profits, which have been climbing for decades. Investors should be cautious about making hasty conclusions based on a single unfavorable indicator, whether it be rising interest rates, a strong dollar, increasing tax rates, higher energy prices, fewer chances of a rate cut, above-average valuations, or narrowing equity risk premiums.
Colas emphasizes that there are numerous historical instances of markets behaving counterintuitively. The more one looks, the more likely they are to uncover other factors that provide a theoretically sound explanation for stock behavior. This doesn’t mean that investors and traders always act rationally or avoid errors. Instead, it’s a reminder that markets are complex and require analysis that goes beyond simple assumptions based on the movement of one variable.
