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Commentary: How worried should you be about rising interest rates?

Will rising interest rates sabotage the stock market?

That’s the question that many have been asking in recent sessions, given the dramatic rise in interest rates over the last two months. And, since stocks and bonds are competing assets, it certainly makes sense that those high rates could pose a real challenge to the stock market’s rally.Will rising interest rates sabotage the stock market?

I’m not so sure, however. There is precious little statistical data that supports this notion.

Consider a fascinating study conducted nearly a decade ago by Clifford S. Asness, managing and founding principal at AQR Capital Management, a Greenwich, CT-based quantitative research firm. Entitled “Fight the Fed Model,” it appeared in the Fall 2003 issue of the Journal of Portfolio Management. (Click here to read a copy of Asness’ study.)

Asness analyzed whether interest rates are a helpful factor to take into account when determining whether the stock market’s price/earnings ratio represents under- or overvaluation. He came up empty.

Asness’ findings are best understood in terms of a statistic known as the “r-squared,” which reflects the degree to which fluctuations in one thing predicts or explains changes in another. The r-squared ranges between 0 and 1, with 1 indicating the highest degree of predictive power and 0 meaning that there is no detectable relationship.

The table reports the r-squareds that Asness derived from tests of the period back to 1926 on the S&P 500 index (^GSPC – News). Notice that, regardless of whether you’re using the P/E ratio to forecast the market’s one- or ten-year return, you’ll do a whole lot better by focusing just on it — rather than interpreting (and adjusting) that ratio in light of prevailing interest rates.

How can this be? Jeremy Siegel, a finance professor at the Wharton School at the University of Pennsylvania, provided an explanation for this otherwise counterintuitive result in his classic book Stocks for the Long Run:

“Over long periods of time,” he wrote, “changes in the inflation rate [and, consequently, interest rate changes] cause changes in earnings growth of the same magnitude and do not change the valuation of stocks.”

For the record, I’m not saying that you shouldn’t worry about the stock market’s prospects. Indeed, I have written about a couple of reasons to worry in recent columns.

My point is, simply, that higher interest rates are not — in and of themselves — a good reason to lower your expectations of the stock market’s return over the next year, or the next decade.

Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.