Why Higher Rates Haven’t Broken the Stock Market

higher-rates

For most of the past year, investors have been trying to answer what seems like a fairly straightforward question: How can the stock market continue to rise when interest rates keep moving higher? The conventional answer is that interest rates simply do not matter as much as they used to. We are not sure that is right. In fact, there is growing evidence that higher rates are doing almost exactly what we would expect them to do: they are putting pressure on valuations. The basic valuation relationship is well established: higher required rates of return increase the discount rate applied to future cash flows, which, all else equal, lowers their present value.

The interesting part is what has happened next. Earnings have bailed the market out.

As expectations for interest rates have moved higher, the forward price-to-earnings multiple on the S&P 500 has moved lower. Investors are quite literally paying less for each dollar of expected earnings than they were several months ago. FactSet reported that the S&P 500’s forward 12-month P/E ratio stood at 19.2x on September 25, down from 20.4x at the end of the second quarter. Ordinarily, that would be a problem for stock prices, but earnings expectations have been moving rapidly in the other direction.

See more: Stock Market Tug of War: Earnings vs. Rates

There are only so many ways for a stock to increase in value. The company can earn more money, investors can decide to pay more for those earnings, or some combination of the two. This year, investors have been getting substantially more of the former and less of the latter.

Since June 30, the S&P 500’s forward 12-month EPS estimate has risen 8.9%, while the price of the index has increased only 2.7%. Over the same period, the forward P/E multiple has fallen from 20.4x to 19.2x.

That distinction matters because it helps explain what has otherwise looked like a contradiction. Higher rates have not been irrelevant to the equity market. They have shown up through lower valuation multiples. The reason stock prices have continued to rise is that earnings growth has been strong enough to more than offset the pressure from lower valuation multiples. FactSet currently estimates third-quarter S&P 500 earnings growth at 29.1% year over year, up from an estimate of 26.7% at the start of the quarter. If realized, that would mark a third consecutive quarter of earnings growth above 25% and an eighth consecutive quarter of double-digit earnings growth.