Interest Rates Up? Don't Panic

7/9/2012


Conventional wisdom holds that rising interest rates weigh on stock prices. And since 1953, changes in the S&P 500 Index had a slight negative correlation with changes in the yield of the 10-year Treasury note. That means index returns tended to lag during periods when interest rates rose.

The key word here, however, is "slight." Such regression analysis isn't foolproof, but our data indicate changes in interest rates have accounted for less than 5% of the variation in index returns. And over the last 20 years, the index has had a slight tendency to outperform during periods of rising rates.

One 2007 study published in The Journal of Portfolio Management based on stock returns from 1976 through 2003 found that a 1% rise in the yield of a portfolio of Treasury bonds should cause the S&P 500 Index to fall just 1.8%. Keep in mind that a 1% change in bond yields is a pretty big deal, while the S&P 500 has risen or fallen more than 1.8% in nearly two-thirds of the months since 1953. In contrast, the 10-year Treasury yield has moved more than 1% in only six of those monthly periods. In fact, the bond yield has risen or fallen more than 1% in fewer than 20% of the 12-month periods since 1953.

The 2007 study also found that stocks' interest-rate sensitivity is itself very volatile, varying greatly over time and changing very quickly. Other researchers have studied the effects of interest-rate changes on stock prices with mixed — often contradictory — results.

So what does all this mean? Below we present three key conclusions:

Rising rates are no sell signal. The data suggest investors should not shy away from equities just because interest rates are rising, partly because rates tend to rise when expectations for economic growth are improving. At the same time, the positive correlation over the last two decades does not mean higher interest rates benefit stocks. It may simply reflect the fact that other issues have a greater effect on stock prices than interest rates.

Smaller stocks and growth stocks are less vulnerable. The 2007 study found large stocks were more sensitive to interest rates than small stocks, and value stocks were more sensitive than growth stocks. The Forecasts focuses on large-cap and midcap stocks, and the table below features seven A-rated stocks with market values below $15 billion and strong growth characteristics.

Sectors and industries make a difference. Over the last 20 years, the S&P 500 technology, energy, industrial, and materials indexes have tended to outperform when interest rates rose, while rate increases had a slightly negative effect on telecom, utility, and consumer-staples indexes. These results bear out other studies that suggest higher-yielding stocks are more sensitive to interest-rate changes.

STOCKS WITH LESS RATE SENSITIVITY
Smaller stocks tend to be less sensitive to interest-rate changes than large stocks, and growth stocks less sensitive than value stocks. Below we present seven A-rated stocks with market values below $20 billion and solid growth histories. We limited the table to stocks from the six sectors with the highest performance during periods of rising interest rates. Stocks recommended for purchase are listed in bold.
------------ Quadrix Scores ------------
Company (Price; Ticker)
Market
Value
($Bil.)
Momen-
tum
Value
Quality
Overall
Sector
AGCO ($45; AGCO)
4.4
74
93
91
95
Industrials
Bed Bath & Beyond
($62; BBBY)
14.3
62
64
94
81
Consumer discret.
CA Technologies
($27; CA)
12.6
64
76
88
94
Technology
CF Industries
($193; CF)
12.9
92
90
100
100
Materials
Macy's ($34; M)
14.4
75
83
63
80
Consumer discret.
Plains All American
($82; PAA)
12.9
82
57
71
86
Energy
Wyndham Worldwide
($53; WYN)
7.9
91
35
83
80
Consumer discret.
Note: Quadrix scores are percentile ranks, with 100 the best.

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