Higher Interest Rates Don't Necessarily Mean Lower Equity Prices

 |  Includes: GLD, SPY
by: Robert Wagner

Just yesterday I wrote an article outlining a theory that higher interest rates were not bad for equities, and that in fact higher interest rates should help drive equities like the SPDR S&P 500 (NYSEARCA:SPY) higher. Yesterday's article wasn't the first time I wrote about this theory.

The theory I outlined was that economic strength would drive interest rates higher, and unlike past market cycles, higher interest rates would be welcomed by the equity markets and signal a return to "normalcy."

Going out on a limb like that and promoting a theory that is so unconventional always makes me a bit nervous, but ever since the 2008 crisis I have always maintained that investment professionals should throw out the economic text books. Things were getting flipped on their heads. I have always maintained that 2008 sent the financial markets into uncharted territory, and that relying on outdated historical maps were likely to result in poor performance. The best example is how gold and SPDR Gold Trust (NYSEARCA:GLD) has rallied to all time highs without any real sign of inflation, and that unprecedented money printing didn't cause inflation either. This time things were and are truly different, and investors need to frame their investment decision in the context of a market recovering from a near disastrous crisis, something that isn't baked into most historical models, theories or retirement plans.

Fortunately I'm not out on a limb alone with this theory. Ironically, just one day after my article was published, CNBC interviewed Brian Belski, BMO's Chief Investment Strategist, who made almost the exact argument.

When the Fed begins to taper that is an absolutely good thing for equity markets because that will tell you the economy is on sound footing and that stocks prices can, would and should go up.

This recent video also supports that theory, so the idea looks to be catching on.

The market speaks for itself. any mention of tapering does upset the market. why shouldn't we fear it? i think we have to think about why there is tapering and if there is tapering later in the year or in early 2014 because the economy is showing greater signs of resiliency... if economic growth is picking up, that's the cause of the fed starting to taper, that's a positive for corporate profits and the market.

That theory is counter to almost everything taught in textbooks, but that is because textbooks usually teach about normal markets, and during a normal market the Fed increases interest rates to slow economic growth and lowers them to spur economic growth. This time is completely opposite. This time the meaning of higher interest isn't that the economy is over heating and needs to be slowed, this time higher interest rates will represent a return of confidence to the markets. Unlike past times when higher interest rates acted like a pit stop for a NASCAR race to cool the engines, this time higher interest rates represent the disconnecting of life support from a patient being transferred from the critical care ICU to the general hospital for further treatment and recovery. That is a good thing, and should not inhibit a higher equity market.

In conclusion, one of the most difficult aspects of finance and economics is that most models are "multi-variable" and depending on the market conditions one factor may carry more weight than another, and those weights change over time and environments. That is why people always joke about the "two handed economists" because economists always try to outline the significant factors and how changes in one may lead to a change to another. An economist will say, "on one hand lower unemployment will signal a stronger economy, but on the other hand, a stronger economy may result in inflation." Their answers appear to be more of an analysis, than an answer, and they often get perceived as being unable to give a straightforward answer. Most people like simple answers like "if interest rates go higher equity prices will go lower." Clean, simple, understandable and concise. Unfortunately, financial markets can rarely be defined by a single variable model, and simple models rarely work very long. In my opinion the markets that exist today are extraordinary, and historical relationships are likely to break down or function poorly going forward. Because of that, I would expect the classic relationship of higher trending interest rates being bad for equities unlikely to hold this time, at least in the short and intermediate time period. I wouldn't expect interest rates to start having a contractionary impact until they are closer to their longer term averages, and there is a lot of cash on the sidelines that should delay that eventuality. Because of that, I would not expect the unwinding of QE or talks of higher interest rates to have a lasting detrimental impact on equity returns until rates are much closer to normal levels.

When the facts change, I change my mind. What do you do, Sir?

John Maynard Keynes

Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.