Rising interest rates won't necessarily be bad news for stocks

When Benjamin Franklin said, "An investment in knowledge pays the best interest," he may have been anticipating the low to zero interest rates savers and investors have been contending with for years.

Now it seems that rates have finally begun to rise, and contrary to conventional wisdom, that won't necessarily be bad news for stocks.

Since the end of January, the S&P 500 has returned a positive 7.1 percent, while the price of bonds has declined and the 10-year Treasury yield has risen 0.6 percent. Investors have been busy selling bonds in anticipation of the inevitable (and much-anticipated) hike by the Federal Reserve Board while economists and pundits handicap the date of the upcoming rate increase. June? September? 2016?

The market has a way of getting out in front of news and anticipating economic and earnings events. After this year's 0.6 percent rise in bond yields, the question of when the Fed will initiate a 0.25 percent bump in rates seems almost moot; and if history is any guide, when the Fed finally takes action the hike will already be reflected in bond prices and yields. The essential question for investors now is how quickly will the Fed raise rates.

Russell Investments reviewed the (almost) 44-year period from Jan. 1, 1970, through Sept. 30, 2013, to assess the effects of interest rates on stock performance. Over the period measured, the yield on the 10-year Treasury began at 7 percent, peaked at 16.5 percent on Sept. 30, 1981, and then began a steady decline to 2.3 percent by the end of September 2013. It is true that, on average, stocks perform somewhat worse in rising interest-rate environments than they do in declining periods: 9.7 percent vs. 10.7 percent. Hardly a disaster. And it is important to note that when rates are rising, according to Russell, stocks perform best when the increase is measured and slow.

Interestingly, the research also shows a portfolio allocation balanced at 60 percent in stocks and 40 percent in bonds generates very similar returns in rising and falling interest rate environments: 9.4 percent vs. 9.9 percent. Despite those who claim that exiting stocks during periods of rising interest rates is prudent, history shows that doing so is anything but.

Oh, and there is one more thing. Rising rates tend to favor active stock selection, as opposed to passive investing (think indexed ETFs or mutual funds). According to Joe Mezrich, head of quantitative investment strategy at Nomura Securities, from 1962 to 1981, when 10-year Treasury yields more than tripled, the excess median return produced by active managers of large-cap mutual funds was 3.2 percent per year when compared with the S&P 500. On the heels of the past 30 years of mostly lagging performance from active managers, that is welcome news and the kind of knowledge that pays.

Nancy Tengler spent two decades as is a professional investor. She is an author, financial-news commentator and university professor. Reach her at nancy.tengler@cox.net.