May 26, 2022

StrategisChhr

Skillful Business Crafters

Opinion: The surprising twist in what rising inflation means for the stock market

CHAPEL HILL, N.C. – Here’s another entry for Ripley’s Believe It or Not: Bear markets in stocks are more likely to begin when interest rates are falling than when they’re rising.

That’s important information to keep in mind at a time when inflation is at a 40-year high and interest rates are steadily rising. In the wake of this month’s report of higher-than-anticipated inflation, economists increasingly expect that the Federal Reserve will raise hikes at each of its meetings this year until at least the fall—and have increased the probability of a half-a-percentage point hike in March rather than one half that size.

Read: ‘Blowout’ U.S. inflation leads traders to raise bets for a half-point Fed rate hike in March to as high as 83%

But the data don’t lie. Consider what I found upon analyzing the trend of the 10-year Treasury yield
TNX,
-3.74%

TMUBMUSD10Y,
1.943%
prior to the 17 bear markets since 1962 that appear in the bear-and-bull-market calendar maintained by Ned Davis Research. (I began my analysis then because that is the earliest year for which the U.S. Treasury has historical data for the 10-year Treasury.) In 10 of those 17 bear markets, the 10-year yield on the day the bear market began was lower than where it stood three months previously.

In the current case, in contrast, interest rates have risen markedly: The 10-year yield is at 2.01% today versus 1.56% three months ago.

These results don’t guarantee that we’re not in the beginning stages of a new bear market, I hasten to emphasize. After all, seven of the last 17 bear markets did begin at a time when, like now, the 10-year yield over the trailing three months had risen. Indeed, it’s possible that a bear market began in early January, when the S&P 500 index
SPX,
-1.90%
hit what so far is its all-time high. It currently is about 4% below that high.

The proper conclusion is that interest-rate trends are an unreliable guide to when bear markets will begin. That in turn means that if interest rates were magically to come down in coming months, the bulls shouldn’t necessarily breathe a sigh of relief.

Why rising rates don’t necessarily cause a bear market

The reason that many of you are surprised by my findings is that you are guilty of something economists call “money illusion” or “inflation illusion.” I discussed these illusions at greater length earlier this month, but in a nutshell they arise when you try to compare a nominal rate (unadjusted by inflation) with a real rate (adjusted by inflation).

As a result, investors will incorrectly update their stock-market valuations in the wake of higher inflation and interest rates. They will, quite properly, discount future years’ earnings at a higher rate, with the result that the present value of those future earnings is lowered. But that’s only half the equation. They fail to recognize that, when inflation is higher, future years’ earnings tend to grow faster than they would have otherwise.

These two effects of higher inflation and interest rates at least somewhat cancel each other out. Nominal earnings will be higher, but they must be discounted at a greater rate back to present value. Inflation and money illusion is recognizing the second of these two consequences but not the first.

The bottom line? Higher inflation and interest rates are not necessarily the threat to the bull market that most assume that they are.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected].

More on inflation and the Fed

The average household is spending an extra $250 a month due to high inflation — but middle-aged Americans are paying even more

Has inflation peaked? Don’t bet on it

Stock investors know not to fight the Fed, but you can fight the Fed Model

https://www.marketwatch.com/story/the-surprising-twist-in-what-rising-inflation-means-or-the-stock-market-11644517927