Nearly all mainstream economists agree that at some point, higher interest rates and inflation hurt stock prices. “Investors are right to be concerned,” said Alan Blinder, professor of economics at Princeton and former vice chairman of the Federal Reserve.
Nuveen’s Mr. Nick said it’s important for investors to look beyond the headlines about rising interest rates to ask why they’re going up. Rising rates can be a sign of a healthy, growing economy, and if the Fed can keep it from overheating, it may well be good for stocks. But if the Fed is forced to raise rates to ward off inflation, the risks of a recession — and lower earnings and stock prices — are much greater.
Mr. Nick said the current situation “looks like a little bit of both,” which leaves him cautiously optimistic, but in no rush to add to stock positions. He hasn’t made any changes to Nuveen’s model portfolio allocations.
“Unlike the last few corrections, we don’t see this as a V-shape recovery, where investors might blink and miss it,” he said. “I think stocks can rise by the end of the year, but it will be a slower grind back.”
Others are less sanguine. The Harvard economist Martin Feldstein, who has long studied the complex relationship among interest rates, inflation and stock prices, has been warning for months that markets are highly vulnerable to rate increases and inflation. Markets face “a fragile financial situation, and potentially a steep drop somewhere up ahead,” he wrote in an op-ed piece in The Wall Street Journal just weeks before the recent correction.
Even after the recent pullback, he expects more declines. “When interest rates rise back to normal levels, share prices are also likely to revert to previous norms,” Mr. Feldstein told me this week.
That could be a long decline. Even after the recent 10 percent correction, stocks remain richly valued by historical norms. James Stack, a market historian and president of InvesTech Research, pointed out that a common valuation measure — the price to earnings multiple for the S.&P. 500 — recently went from 26 times earnings to 23.4 after the correction, which is a level reached less than 10 percent of the time since 1928. (The long-term average price-to-earnings ratio for the stock market, excluding extreme periods, is about 14.) “This is a very richly priced market no matter how you slice it,” he said.
Mr. Stack recently lowered the stock portion of his model portfolio to 72 from 82 percent out of concern over high valuations and rising rates. He noted that during 11 periods since 1955 when the Federal Reserve was tightening credit, a so-called “soft landing” was achieved only twice — in the mid-1960s and mid-1990s — and that a recession followed in every other instance. “Once the Fed starts a tightening cycle, it is very difficult to avoid a recession before it is over,” he said. He hasn’t increased the allocation since the sell-off.
Mr. Blinder told me that stock valuations reached such extreme levels that he started reducing his equity holdings several months ago. “I sold too early,” he said with the benefit of hindsight. “I missed the last 15 percent gain and I missed the 7 percent drop.” He hasn’t resumed buying at current levels.
The Fed is now two full years into its current cycle of rate increases, which is already longer than most tightening periods. But the benchmark interest rate for 10-year Treasuries, which has recently risen to just over 2.9 percent, still has a long way to go before reaching its long-term average of 6.24 percent. The Fed has forecast three more quarter-point rate increases this year, but that would only bring the Federal funds rate to 2.25 percent.
“Historically it’s impossible to name any threshold at which rising rates might trigger a rush for the exit or a bear market,” Mr. Stack said. “In most cases, stock prices can weather rising interest rates until they reach 5 to 6 percent, which was the case in 2000 and 2007.”
But after years of such low interest rates, and with stock valuations extremely high, he said, “we’re dealing with what might be the most interest rate-sensitive stock market in our lifetime.”
If this is, indeed, the last stage of the long-running bull market, and interest rates continue to rise, as the Fed has suggested, some sectors typically perform better than others. According to InvestTech, the best performing sectors during periods of rising rates since 1972 have been health care, energy, consumer staples and telecommunications. During the last year of a bull market, the best performing sectors have been energy, health care and technology. Health care and energy show up in both categories.
Of course no one knows for sure when the bull market will end — or whether it already has. But investors are clearly on edge, and the last few weeks may be a preview of what the end looks like.
“There are a lot of very bright people on Wall Street who are all counting on being the first out the door when the party ends,” said Mr. Stack. The recent plunge “showed just how small that door may get.”