How Stocks Perform When Rates Rise and Multiples Have Expanded
How High Can US Stocks Go?
However, investors should still be a bit nervous for another reason. Not only have multiples risen, but interest rates are increasing as well. In the past, higher multiples and higher rates have represented a challenging combination. In those instances when multiples rose but rates were lower, the average return for the market was more than 9%, in-line with the historic average. In other words, to the extent that rates are dropping, rising multiples don’t represent the same degree of headwind as when rates are rising. However, in the 14 instances between 1954 and 2013 when multiples rose and interest rates rose, the average return on the S&P 500 in the following year was a relatively paltry 2.3%.
Market Realist – Expect poor stock performance when rates rise.
In the three months following an initial rate hike, the S&P 500 (VOO) (IVV) has performed surprisingly better if valuations have been increasing over the past year, as the graph above shows. This is probably because the momentum that led multiples to expand continued despite tightening.
Over the longer term, however, multiple expansion, combined with tightening, leads to negative returns. In comparison, the S&P 500 (SPY) has seen double-digit returns when the market is characterized by multiple contractions in the years preceding tightening. In these scenarios, the index has typically seen much better returns in the six months and 12 months following the tightening.
In the six-month period after the rate hike, the index rose by 4.4% when multiples contracted in the previous year—compared to 1.2% when multiples expanded. The index has seen returns of 10.8% in the 12-month period after the initial rate hike—when the market is characterized with multiple contractions. It returned -2.2% when the market saw multiple expansions in the preceding years.
Lately, US stocks (QQQ) (DIA) have shown signs of slowing down. The strong labor report led the markets to believe that the Fed would raise rates sooner rather than later.
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