The Fed just raised the interest rate on December 13th and three more increases are expected in 2018. How would these hikes affect the stock market?
From Short-Term Rate to Long-Term Rate
The rates that are more relevant to the stock market are the long-term rates. These rates are determined by market supply and demand forces, not the Fed. The chart below shows that the federal funds rate and the 10-yr Treasury rate track each other and go through diverging-converging cycles. From where we are right now, the short-term interest rate appears to be catching up with the long-term rate. If by the end of 2018 the Fed raises the short rate by a total of 1%, the 10-year rate is likely to increase less than that.
What’s the Impact on the Stock Market?
Higher interest rates lift the discount rates and lower the fair value of the stock market. Popular valuation metrics including CAPE have labelled the stock market ‘overvalued’ since 2010. If the market is already overvalued, an increase in the interest rates should trigger selloffs. However, when the Fed raised the federal funds rate for the first time after the financial crisis from 0.25% to 0.5% in December 2015 and then again from 0.5% to 0.75% in December 2016, there were some hiccups but the stock market quickly shook off any negative impact. The reason is simple. Even after its continuous rally to this day, the market is still not overvalued. PE metrics overemphasize the comparison of the historical average and ignore the current economic backdrop. In a low-rate, low-inflation environment as we have now, the valuations tend to stay above their long-term averages.
Fair value calculations, on the other hand, demonstrate a better track record of predicting where the market might be heading. The calculation proposed by Morgan Stanley uses average corporate borrowing cost (Moody’s Baa Yield) to discount forward earnings. In late 1990s and early 2000, it showed that the S&P 500 was greatly overvalued; subsequently, the index fell back to its fair value. After 2008, the calculated fair value showed that the S&P 500 was oversold and the stock market has responded by rising toward its fair value since then.
Goldman Sachs looked at the market fair value in a similar way using 10-yr Treasury rate. At the current level of 2.35%, they concluded that the fair value of the S&P 500 is 2801 vs the actual 2626 (as of November 2017). After adjusting the equity premium to macro conditions, the negative relationship between the S&P 500 fair value and the 10-year Treasury rate has been pushed further outward (see chart below), giving the stock market more upside potential.
Compared to PE ratios, fair value measures reconcile better with the reality and provide a clearer path from the interest rate to the stock market valuation. By these measures, the long-term interest rates have to go up at least a whole percentage point in order to close the current valuation gap and bring the S&P 500 up to its fair value. The Fed rate hikes in 2018 would likely push up long term interest rates, but only moderately. If the earnings continue to grow, it will take the market even longer to catch up with its fair value. In other words, I think the market valuation will hold up next year and stocks have more room to go even if the rates increase. I’ll update the data periodically.
Disclosure: I/we 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.