Personal Wealth Management / Expert Commentary

Fisher Investments Reviews Why High Bond Yields Don’t Doom Stocks

Fisher Investments’ founder, Executive Chairman and Co-Chief Investment Officer, Ken Fisher, examines the correlation, or lack thereof, between bond yields and stocks. According to Ken, people often look at markets with biases—a common example being the idea that interest rates move inversely (or opposite) of stocks. Ken says correlations between stock prices and interest rates over any significant period are low and are far from the inverse relationship that some people suggest.

Ken believes the main interest rate driver is future inflation expectations. Higher perceived long-term inflation typically equates to higher long rates. Ken notes that future earnings potential of stocks—and not interest rates—are largely why stocks can go up while interest rates are rising.


Ken Fisher:

Why is always a tougher question to answer than what. What is just an identification issue. Why requires understanding causality. Now often in markets, people don't know what's what. Because they start with biases that make them believe X causes Y, or y happens randomly or something. And sometimes those things are true, but sometimes they're not. The fact is one very common perception, that we've had a lot of over the course of the last couple of years is if interest rates go up, stocks have to go down.

Now let's just clarify that. We have, and this is something that I tell people all the time, whenever you've got two things like stocks and interest rates, or stocks and bond prices. That occur regularly over a long period of time, like those. You can go online. Download pricing into a spreadsheet. Most financial spreadsheets today have a correlation function built into them. So you all have to do is press a button and you don't have to learn statistics like I had to do when I was young, and it'll tell you the correlation between the two. If they wiggle perfectly together, the correlation is one. If they move perfectly in inverse, when the one goes up, the other goes down perfectly, it'll come out as a negative one. If there's no correlation at all, and they wiggle randomly, then they're going to come out at zero in between 1 and -1. Slight positive numbers mean there's a slight tendency to wiggle together. Slight negative numbers mean there's a slight inverse tendency, but it's not overwhelming, so it might not happen this time.

And in fact, when we look at, let's say, ten-year bond rates and stocks, the general presumption is if ten-year rates go up, if bond rates go up, then stocks should fall. But in fact, when you run correlations over any significant period of time, when I say significant, I mean five year stints, five years here, five years there, five years the other, you see slightly positive tendencies for stocks and interest rates to move the same direction counter to what people believe is the issue.

Now, before I get into the issue of why, which I will in a moment, let me just make the point that before you get to why it's always helpful to get to what? Because you can't really answer why if you don't know what. Because if you don't know what's what, you don't know why what's what is working. Make sense?

So the point I want you to see is that the core concept that stocks and bonds move inversely—that rising rates make stocks go down, that falling rates make stocks go up— happens sometimes. It's a weak tendency for them to move together, for higher interest rates to move with rising stock prices. So you can't count on it now. You can't bet on it now, but you can't bet against it either. It's over the very long term that correlation is about 0.2. Remember 0 would be no correlation at all. 1.0 would be a 100% tight correlation, and they wiggle together perfectly. A 0.2 is not something you bet on.

So let me just give you an example of this before we get into why. Last year, rates went up. What happens when rates go up? Stocks fell and bonds fell. But then from the bottom in October of last year, 2022, most of the increase in interest rates for bonds would still happen. Bond rates kept going up. But so did stocks. This year, stocks went up and rates went up. Last year, they went the other way. You follow my logic? There's not a consistency. Why isn't there? Because bonds do one thing when interest rates go up. For whatever reason, bond prices fall. It's a mechanical function for governments. It's a little bit less mechanical for something like corporates because there's more individual business risk for the corporates.

The biggest cause of long rates going up—or falling down— is future perception of inflation. If people believe it could be a lot of inflation, long rates are likely to be high because lenders will demand to be compensated for that inflation, or they won't make the loans. You want to make a loan for 20 years and you think there's going to be a lot of inflation, you better get paid pretty well for it. Well, think about a business over those 20 years. With the inflation over time, maybe not immediately so, it'll be able to raise its prices, caused by inflation, which offsets that. Further, businesses, unlike a bond, have the ability, of which some succeed and some fail, to innovate and develop new, never yet done things that make everything better. And when one business does that and people finally catch on that it's doing it, others tend to imitate, and things do get better and that helps improve earnings.

The original concept behind all of this, which is a nice theory, but false, is that stocks have to have what's called an earnings yield. The inverse of a price earnings ratio. Price earnings ratio is price divided by earnings. Earnings yield is earnings divided by price. That's significantly higher than a bond yield. So for example, let's say bonds were yielding 5%. And let's say that the price of the stock was ten and the earnings was one. Then that would be a PE of ten, but the earnings yield would be one divided by 10 or 10%. And the earnings yield would be twice the bond yield, and gee you know that makes sense that you might want to own that 10% earnings yield even though it would be more volatile, and there's business risk, then owning the 5% bond yield.

But that doesn't really work because when you buy the bond yield, that's what you get. The price may go up and down, but if you hold it until maturity, if you buy a bond for 20 years, it's a 5% bond. You hold it to maturity, you get that 5% coupon every year. The price may wiggle in between, but at the end, you get back the original money that you put in. The original $1,000, in nominal terms, no inflation adjustment.

The presumption of the earnings yield is that's a snapshot of today. But the future earnings yield is going to come down to what are the earnings in the future? What's the price in the future? And the fact of the matter is, that if the earnings go up in the long term, the future earnings yield, is much higher than the present earnings yield. And that comes from inflation, that comes from growth. That growth could come from innovation. It just could come from the economy. If the economy is growing at a couple of percent a year, over the long term, that's accruing to the earnings. That's why stocks can go up when interest rates are rising. Sometimes they don't. It's not a tight correlation. I explained this before, but the driving feature of why is because owning businesses is very different than owning bonds.

Thank you for listening to me. I hope my long rant here was useful for you.

Hi, this is Ken Fisher. Subscribe to the Fisher Investments YouTube channel if you like what you've seen. Click the bell to be notified as soon as we publish new videos.

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