The relationship between interest rates and the stock market.

 Both the Futures markets and the Federal Reserve expect the Fed Funds rate to reach around 1.50% during the first half of 2023.  Given that, investors are concerned that the market is in for a serious correction.  

You can read my complete study of the relationship between rates and the stock market at: 

Stock Market Study at Slideshare.net 

Stock Market Study at SlidesFinder.com

Higher rates entail a higher discount rate of prospective earning streams, therefore reducing the net present value of a company's stock.  On the other hand, higher rates are also often associated with economic growth  resulting in faster earnings growth.  Thus, higher discount rate vs. potentially faster earnings growth are countervailing forces.  Consequently, the relationship between (rising) interest rates and the stock market may not be as one-sided as anticipated.  

Using quarterly data going back to 1954, visually, we can observe that the relationship between interest rates and the stock market is rather weak, approaching randomness.  Whether we focus on the Feds Fund rate (FF) or the 10 Year Treasury one, a quarterly change in such rate is not that informative regarding quarterly change in the S&P 500 level.  

The correlation between the change in the S&P 500 and change in FF is only negative - 0.19.  And, it is negative - 0.24 with the 10 Year Treasury rate.  Both translates into R Squares that are very close to Zero, indicating that rates explain very little of the S&P 500 behavior.  That is pretty much what the graphs above are conveying.  The regression line has a slope that is very flat.  The confidence interval of the data-points location along that line is pretty wide.  The red ellipse show an image of near randomness.  

Focusing on 4-quarter change in the FF rates vs. the S&P 500, we compiled the following table based on data going back to 1954.  And, we focused on various FF rate increase ranges that reflect the prospective ones we are facing over the next year. 

As shown on the table above, FF increase levels do not clearly differentiate between S&P 500 level changes over 4 quarters.  Based on investment theory and monetary policy, you would expect that the higher the rise in FF, the lower the rise in S&P 500 over the reviewed period.  But, the empirical data does not quite support these common assumptions.  

Next, I built an OLS regression that also factored the influence of economic growth (rgdp), inflation (CPI), and quantitative easing (qe).  All variables were fully detrended on a quarterly basis. 

The regression shows a conundrum often encountered in such econometrics models.  The independent variables are statistically significant.  This suggests you have a pretty good model.  But, not so fast ...  this model is actually pretty poor with an Adjusted R Square of only 0.19.  It also has a very high standard error that is nearly as high as the standard deviation of the dependent variable, the change in the S&P 500 level. 

 

The facet graph above shows how mediocre this econometrics model is.  The residuals (red) capture a lot more of the volatility and the trend of the S&P 500 changes (black), than the model estimates (green). 

Next, I developed a couple of Vector Autoregression (VAR) models, one with 1-lag, and the other with 3-lags.  These VAR models were pretty much disastrous.  Probably the most efficient way to demonstrate that is to show that the VAR models were hardly any better than simply using a Naive model that would use as a single estimate the S&P 500 average quarterly change, and take its standard deviation as the standard error of this Naive model estimates. 

As shown above, the standard error of the two VAR models is hardly any lower than the standard deviation of the S&P 500.  The OLS regression model is clearly better than the VAR models.  Yet, its performance in terms of true error reduction (- 10.2%) is nothing to write home about. 

Additionally, the VAR models generated Impulse Response Functions that went in the wrong direction.  See below within the VAR model with 3 lags, the change in the S&P 500 over 8 quarterly periods in response to an upward 1 percentage point shock in FF.  It is positive.  That's clearly the wrong direction (as far as both investment theory and monetary policy are concerned.  

All of the above suggests that interest rate rises are not that deterministic in anticipating stock market downturns.  That may be in part because prospective FF rises or declines are already priced in the stock market through the Futures market.  Going forward, the market may very well encounter rough waters (as of this writing it already has).  But, it is for many more reasons than interest rates and even overall monetary policy alone.

 

Will stock markets survive in 200 years? Some won't make it till 2050

Within a related study “The next 200 years and beyond” (see URLs below), 

 

The next 200 years at Slideshare

 

The next 200 years at SlidesFinder

 

... we disclosed that population and economic growth can’t possibly continue beyond just a few centuries.

 

Just considering what seems like a benign scenario: 

 

 … Zero population growth with a 1% real GDP per capita growth … 

 

… would result in the World economy becoming 8 times greater within 288 years and 16 times greater within 360 years.  Thus, the mentioned scenario, as projected over the long term, is not feasible.  

 

This study contemplates how will stock markets survive in the absence of any demographic and economic growth.  The whole body of finance supporting stock markets (CAPM, Dividend Growth model, Internal Rate of Return, Net Present Value) evaporates in the absence of a growth input (market rate of return, dividend growth, etc.). 

 

And, current trends over the past few decades confirm the World is already heading in that direction.  In our minds, this raised existential considerations for stock markets. 

 

This study uncovered several stock markets that already experience current and prospective growth constraints.  And, the survival of several of those markets till 2050 appear questionable. 

 

Place yourself in the shoes of college graduates entering the labor force and investing in their 401K for retirement.  The common wisdom is to invest the majority of such funds in the stock market to reap maximum growth over the long term.  Such a well established strategy, would most probably not work out for the majority of the 11 markets reviewed.  And, it could be devastating if the college grad lives in Greece, Italy, or Ukraine. 

 

Similar considerations, within the same mentioned countries, would affect any institutional investors focused on the long term such as pension funds, endowment funds, insurers, retail index fund investors, etc.

 

In the US, we may be spared these bearish considerations, but for how long?  A century or two from now, we in the US may be affected by the same considerations.  

 

You can see the complete study at the following link below: 

 Stock market in 200 years at Slideshare