Real Interest Rates

I started out this day mowing the lawn and thinking about a nice recent post at Crossingwallstreet.com that has to do with the outlook for gold prices and asserts that a main driver thereof is real interest rates (i.e. nominal interest rates minus inflation). Naturally, I wondered about the relationship (if any) between real interest rates and the stock market. My hypothesis was that an inverse relationship exists such that the stock market suffers when companies' cost of capital (real interest rate) increases. I'm interested in this potential relationship because I tend to think real interest rates will generally trend higher in the intermediate term as the Federal Reserve is forced to eventually confront inflation pressures by raising short-term rates / soaking up some of the base money supply. I'm not saying inflation pressures exist at present, I'm just inclined to think they are poised to increase over time as lenders and borrowers each become healthy enough to lend and borrow again, thus increasing the velocity of money (i.e. effective money supply).

As shown in the charts above, my hypothesis was not validated. If there is any relationship between real interest rates and stock market returns, it is positive. In other words, when real interest rates increase, the stock market tends to perform better (but the relationship is very tenuous with an R-squared of only about 7%). I think perhaps this is because the causation flows somewhat 'backwards'. When the stock market suffers, investors flock to treasuries for safety thereby driving down real interest rates. Perhaps the problem is how I'm effectively using treasury rates as a proxy for the changing 'cost of capital' for companies in the S&P 500. At a later date, I'll test the stock market returns against corporate bond rates (adjusted for inflation), rather than treasury rates, which is almost certainly a better proxy for changes in the companies' cost of capital.

In the meantime, since the value of treasury bonds tend to increase when the stock market declines, I'll have to give some thought and further analysis to potentially exchanging some stock exposure for exposure to short-term inflation protected treasury securities (TIPS) as a means of smoothing out the model portfolio returns. Or perhaps I'll save that move solely for those times I think the stock market is especially prone to a decline based on my favorite economic indicator, retail sales.

Quote for the Week: "There's nothing wrong with living on the first floor until you've spent time in the penthouse". - William Irvine, author of A Guide to the Good Life.