The Federal Reserve is dead set on raising interest rates to quench inflation.
The key rate to watch is fed funds. It’s now at 3%. And there’s a 97% probability that the rate will top 5% by May of next year. That’s based on futures prices.
Rates haven’t been that high since 2007. Once again, many consumers are feeling the pain of their buying power diminishing.
Higher rates make mortgages and car loans more expensive. Many would-be buyers are already priced out of those markets. Even more will tighten their spending belts in the next few months.
Businesses face higher costs too. Some business expansions won’t make sense at 5% or more. That’ll reduce employment. Businesses who depend on loans to finance inventory may struggle to turn a profit as rates rise.
After 15 years, traders seem to have forgotten how much damage can be caused by high interest rates. Today, I explain exactly how they can wreck the stock market.
How Higher Rates Hurt Stocks
Climbing interest rates push a lot of buttons. Obviously, consumer stress limits corporate profits. That’s one way that higher rates hurt the value of stocks.
Higher rates also raise business costs. When businesses spend more on interest, profits fall. That’s another negative factor for stocks.
Analysts calculate the fair value of stocks with discounted cash flow models. The models use interest rates to discount current dollars. As interest rates rise, today’s dollars lose value.
For example, if interest rates are 1%, then $1 might be worth $0.98 in the model. At 5%, that dollar is worth $0.70. If the price-to-earnings ratio stays at 10, fair value falls from $9.80 to $7. That 29% decline will be reflected in the stock’s price.
All these effects are critical. But another important one involves bonds and is more difficult to model…
Stocks Lose Value When Bonds Gain Appeal
In some ways, stocks and bonds are known as alternative investments. Low rates drove the popular TINA investment strategy.
TINA stands for “there is no alternative” to stocks. When yields on highly rated corporate debt fell below 5% in 2011, institutional managers realized there is no alternative to the stock market if they wanted to maintain high returns for investors. With interest rates near zero, bonds didn’t make sense. That drove more funds to stocks as managers accepted TINA.
On the other hand, higher rates cause fund managers to reduce their allocations to stocks. This is true for individual investors as well.
Imagine being able to buy a 10-year government note yielding 10% or more. Or a 30-year bond with a double-digit yield. That seems like a dream. In the 1980s, that was routine. And many investors locked in high rates.
Right now, 10-years offer 4.1%. Investors get about the same for 30 years. If rates move a little higher, money will start to flow from stocks to bonds.
Now, there’s no way to know how that will affect stock prices. But it could be significant, and it’s certainly bearish.
The bottom line is rising rates will hurt stocks because some investors will see bonds as better investments, and valuation models will show stocks are worth less. This is a deadly combination for the stock market. But we can’t avoid it.
Long-term investors will suffer the most. For a while, they’ll say “stocks always come back” or “it’s not a loss until I sell.” Eventually, they’ll have to accept the reality that they’ve destroyed their financial security. Then, they’ll sell stocks and buy bonds. That will push stock prices even lower.
But it won’t end that way for everyone.
Short-term traders will have the upper hand when it comes to navigating the market. They know times are bad. But by trading for profits in the short run, they’ll be able to avoid the devastating pain that’s the result of buying and holding stocks.
Tomorrow in True Options Masters, Mike Carr will be back to share a short-term options strategy he created to benefit from times like this. You’ll get to see how his method would have made you money in 7 of the last 9 market downturns.
Amber Hestla Senior Analyst, True Options Masters