Rising Interest Rates Are Bullish for Stocks

Wednesday, 29 May 2013 07:45 AM

By Gary Jakacky

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Durable goods are better than expected. Fewer unemployment claims. Housing starts and sales are stronger. Consumer sentiment, leading indicators, on and on. The economy is doing better and better. Old news to my readers and Wall Street, where records fall by the day.

A growing economy has increasing demand for capital. Thus, interest rates usually start to rise.

To permabears, this is somehow a disaster for stocks, and they once again are howling that a crash is around the corner. Since "sell in May and going away " has been such a disaster for short sellers, the new crash date is August, when the Federal Reserve might trim back its bond purchases.

Like most economists, they mix up cause and effect. Interest rates are rising because the economy is STRONGER. Just how is this bearish? Was the collapse in interest rates during the Great Recession bullish?

Instead of bemoaning a rise in interest rates and the end of quantitative easing, investors should be ecstatic. One of the most important distortions in financial markets over the last decade has been the Fed's persistent attempts to keep interest rates low. Not only has this denied savers and retirees of trillions of dollars, it has distorted incentives.

Easy money flowed into gold, silver and other "Chicken Little" assets, instead of technology, energy and manufacturing, which generate jobs and income.

If the theory is too much for you to handle, you can always look at the facts. In the 20th century, there were four multi-decade megatrends in interest rates. We'll use U.S. long-term treasury rates as our guide.

1) From 1900 to 1920, rates rose from 3 percent to just shy of 5 percent. Over this same period, the Dow Jones Industrial Average rose from 53 to 119.

2) From 1920 to 1940, rates fell back to 2 percent from their previous 5 percent peak. The Dow started at 119 and finished at 125. A smaller gain than the previous two decades!

3) The next four decades saw interest rates soar from 2 percent to more than 15 percent by 1981. The lessons here are instructive. From 1940 to 1966 or so, the Dow remained oblivious to higher rates, soaring from 125 to over 1,000 by 1966. In contrast, from 1966 to 1981, the Dow actually fell, from 1,000 to 776. It was in those wonderful Nixon/Carter terms the idea that "rising interest rates are bearish" took root. But this was not the case for the first 26 years. What happened?

Inflation! The great enemy of wealth and hidden tax that transfers wealth from individuals to the Federal government. Leaving aside distortions caused by World War II price controls and rationing, the rate of inflation trended downward for those first 26 years. In contrast, for the final 15 years to 1981, the inflation rate soared to levels typical of third-world nations. (Not surprising. Our redistributionist policies then were typical of third-world countries, as well). It was higher inflation, not higher interest rates, that crushed stock prices during that decade and a half.

Need more proof? Look at the final two decades of the 20th century. Interest rates fell from their 15 percent peak to 4 percent by the new millennium. Stock prices jumped from 776 to just over 10,000. A three-digit Dow became quaint! But we crushed inflation as well. I contend that is what caused this huge increase in stock prices.

The proof? From 1981 to 2000, there were numerous short-term spikes in interest rates, but stock prices rose, relentlessly. But when the Fed abandoned its commitment to low inflation — allowing it to rise steadily from 2000 to 2008, to nearly 5 percent? A lost decade for investors ... the first one since the mid 1960s, when we also lost control of prices.

Currently, interest rates may be about to rise, but inflation — helped by cheaper fossil fuels and relentless cost cutting by retailers — remains in check. Don't expect higher interest rates or modest changes in quantitative easing by the Fed to derail this bull.

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