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The Greenspan Effect - Part II
Impact of interest rates on stock prices

Last week we took a brief look at the purpose and impact of interest rate changes. We looked at how such changes affect your fixed income investments and corporate profits (and stock prices). While last week's article focussed on understanding why rate changes impact your investments, this week we'll focus our attention on a quantitative evaluation of the relationship between US interest rates and stock prices.

Background

Last week we saw that falling interest rates reduces debt servicing costs which, in turn improves profits (if all else remains unchanged). If profits (and the outlook for profits) improve, logic dictates that stock prices must eventually follow. However, that's a simplistic view because interest rates change are almost always accompanied by changes in other components of corporate profits. Falling interest rates usually occur in the midst of slowing economic indicators. A slowing economy usually translates into slowing sales and revenue growth, which can offset the savings in interest costs. Again, this is a generality, with some firms being more sensitive than others. For instance, pharmaceutical companies are typically seen as defensive investments because the demand for prescription and over-the-counter drugs has little to do with economic activity. Though these companies can see big fluctuations in profits, such fluctuations aren't usually tied to the country's economic well-being. That being said, let's take a look at how interest rates have impacted stock prices in the past.

Stock prices and short-term interest rates

History has generally supported what we see on a daily basis - stock prices do better when interest rates drop and worse when they rise. I examined the month-end effective Federal Funds rate in relation to the monthly returns of the S&P 500 total return index (US$) over the past sixteen years to quantify this relationship somewhat. My findings were not earth shattering, though they do support the concepts discussed in this and last week's articles.

From October 1984 to December 2000 (194 months), this key interest rate has increased about as often as it has decreased. Before getting into specific numbers, it is important to note that there are many factors that affect stock returns, while some of the stock price movements (especially in the short-term) go unexplained. That said, hikes in the Federal Funds rate during the period studied coincided with the following performance figures for the S&P 500:

  • Average monthly return: 0.40 per cent (or 4.97 per cent annualized);
  • Highest monthly return: 9.78 per cent (February 2000);
  • Lowest monthly return: -21.14 per cent (October 1987); and
  • Percentage of negative months: 39.6 per cent.

    Though it now seems very far away, the positive monthly return of 9.78 per cent in February 2000 seems to contradict conventional wisdom but that was a period in which not all things remained equal. Early last year, tech stocks were coming off of a stellar year. February capped an unprecedented run up in tech stock prices, when projections of long-term revenue growth seemed to be continually revised upward. Such lofty expectations more than offset the then perceived impact of a 25 basis point rate hike. (Recall that 25 basis points equals 0.25 per cent.) However, looking at the stock returns during all periods of monetary tightening supports the hypothesis that historical rate hikes have hurt stock prices.

    Turning our focus to interest rate drops (which is what appears to be unfolding for this year), we find the following results for the S&P 500 over the past sixteen years:

  • Average monthly return: 2.19 per cent (or 29.72 per cent annualized);
  • Highest monthly return: 12.69 per cent (December 1991);
  • Lowest monthly return: -9.43 per cent (August 1990); and
  • Percentage of negative months: 25.8 per cent.

    While the above numbers show that interest rate drops don't make stock gains a "sure thing" by any means, history has demonstrated that it's a much more positive environment in which to be invested overall. Again, the big caveat here: interest rates alone don't drive stock prices. Another example is found by looking at the month of August 1990. At that time, North America was in the midst of one of its deepest recessions in history. A standard drop in short-term rates wasn't nearly enough to stir up the sort of economic impact and optimism needed to prop up sagging stock prices that year. It took time before the impact of falling rates was materialized in stock prices, and then in economic statistics.

    The two largest differences between falling and rising rates are the respective average returns and frequency of negative months. Over the past sixteen years, stocks have gained about five times as much when rates fall, as compared to periods of rising rates. Also, the frequency with which investors see negative returns is substantially lower when rates drop (25.8 per cent), compared to periods of rising rates (39.6 per cent).

    Performing this same historical analysis using long-term bond rates yields very similar results.

    Portfolio positioning

    There are two factors that generally point to further drops in short-term interest rates this year: economic statistics and term structure. Economic numbers pointing to a slowdown have been emerging, making any kind of rate hike unlikely this year. Further, the gap between long-term and short-term rates is extremely narrow. A more typical structure would see long-term rates stand about 150 basis points higher than short-term rates.

    In any event, this two-part series on interest rates wasn't meant to be the basis for any type of prediction. Rather, it was intended to give investors greater insight into why interest rates affect their investments, and how. Investment strategy should continue to be driven by individual objectives and constraints. On a secondary basis, that strategy can be fine-tuned somewhat to reflect an investor's sentiment in the intermediate term.

    Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
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