Debunking the Rate Myth
08-Nov-02 09:14 ET
[BRIEFING.COM - Robert Walberg] One common assumption among investors is that declining interest rates are good for stocks. Conversely, rising rates are perceived to be bad for stocks. Consequently it was not surprising to see investors react positively to news that the Fed had slashed the funds rate by 50 rather than 25 basis points. With the funds rate at its lowest level in over 40 years, stocks must be a good buy, right. Wrong.
As the chart below clearly shows, stocks have spent the past couple of years mirroring the movement in rates. In other words, as rates have fallen so to have stock prices. If this pattern continues to hold, then the aggressive action by the Fed spells short-term trouble for stocks. The question is why?
The answer is simple. Rates are tied to the strength of the economy. Falling rates signal a weak or weakening economy, while rising rates indicate a strong or strengthening economy. Despite beliefs to the contrary, Greenspan & Co. don't have a crystal ball when it comes to forecasting the economy. Nevertheless, their decision to move swiftly and decisively on cutting rates the other day was perceived by many on the street as a sign that the economy is in worse shape than originally thought.
Why does it matter that the economy may be slowing down? Well, sluggish economic growth makes it more difficult for companies to achieve strong earnings growth. The improvement we've seen in earnings over the past few quarters has been due more to soft comparisons and improved operating efficiencies than to a pick up in end-user demand. While improved operating efficiencies are good for the long-term health of corporate America, without a rise in demand pricing power won't be there to drive bottom-line growth over the short-term.
In the end, it is earnings not rates that drive stock prices. And for earnings to start growing at a more robust rate, we're going to need to see a rise in business investment and consumer demand. Two things which are likely to prompt a rise in rates as well.
So if you're looking for a buy signal on stocks you might want to wait until rates start rising again. Unfortunately, rates currently signal that stock prices might need to back up a bit over the next few weeks as yields are falling. Might seem counterintuitive, but for at least the past couple of years the correlation between rates and stocks has been relatively strong.
Robert Walberg, Briefing.com |
