Is the stock market headed for a sea change? That’s the argument investor Howard Marks makes in his most recent memo. The sea change Marks is referring to: For forty years, interest rates in the United States declined steadily—from a peak of 20% in 1980, to 0% in 2020. The result, Marks argues, was a steady tailwind to the stock market. In January 1980, the S&P 500 Index stood at 108. At its peak early last year, it topped 4,800, marking a period of impressive growth. Marks acknowledges that innovation played an important part in that growth—think of all the companies and technologies created since 1980. Still, he argues, “I’d be surprised if 40 years of declining interest rates didn’t play the greatest role of all.”
That brings us to the sea change: Over the past year, the Federal Reserve has reversed course, lifting its benchmark interest rate by more than four percentage points. Not coincidentally, over that same period, the stock market has dropped about 15%, with many individual stocks down far more. Where interest rates go from here is an open question. But one thing is clear: It would be mathematically impossible for rates to drop another 20 percentage points.
As a result, Marks paints a downbeat picture for stock market investors. Among the adjectives he uses to describe this new era: guarded, uncertain, hesitant, scarce. But should Marks’s outlook concern you? Below are some observations on this question:
On the facts, I agree. There’s no question that four decades of declining interest rates provided an enormous tailwind. But that doesn’t necessarily mean the next four decades will deliver the opposite. In other words, there’s no reason to expect that rates will now rise by 20 points. That’s because economic conditions today are very different from the way they were in 1980. Back then, the Fed cranked rates up to 20% because it had little choice. Inflation had been stubbornly high—hitting 13.5% at the beginning of 1980—and thus policymakers were stymied. In contrast, while today inflation is high, it has been showing signs of improvement. The most recent Consumer Price Index reading was 6.5%, down from 9.1% in the middle of last year.
While anything could happen, it appears things are now headed in the right direction. If the Fed succeeds in bringing inflation fully under control, there would be no need to continue raising rates indefinitely. We might still see some more increases this year, but then rates would level off. If that’s how things turned out, then interest rates wouldn’t necessarily represent an indefinite headwind for stocks. Instead, they would become more of a neutral factor, and that wouldn’t be such a problem, as explained below.
Stocks can still prosper. It’s important to keep in mind the fundamental driver of stock prices, which is corporate earnings. Higher rates do put a dent in profits for some firms—if they have debt—but in general, there’s no reason to think that companies will be less productive in the future than in the past. They’ll still innovate and develop new products, which drive earnings growth. Population growth also contributes to earnings growth.
As Marks points out, higher rates do cause investors to put a lower value on earnings—owing to the way present-value math works—and that’s a headwind for stocks. But it’s not a permanent headwind. In other words, we shouldn’t expect stocks to fall continuously into the future. Indeed, stocks would only fall continuously if interest rates rose continuously. And as noted above, the latest data suggests that’s not where things are headed.
Another driver of the stock market is demand. Even though stocks are relatively less attractive compared to bonds in a world of higher interest rates, stocks should still be, in absolute terms, more attractive over the long term. Suppose, for example, stocks return only 7% on average in the coming decades, compared to 10% historically. That would still beat the 4% to 5% that bonds are paying. For that reason, most people will still prefer the stock market for their long-term savings, and that will provide ongoing demand for stocks. That demand would help support stock prices. It would take a long period of stock market malaise to turn investors off from stocks, in my view. That’s because there is no obvious alternative, and because, simplistic as it may sound, savers need somewhere to go with their money.
Higher rates aren’t all bad for investors. Interest rates function as a sort of redistribution mechanism. When rates are low, they punish bondholders and reward investors in risky assets, such as stocks. When rates are higher, bondholders benefit while stock market investors don’t do as well. Investors who own both stocks and bonds, then, are hedged, though it’s not perfectly proportional. Lower rates, which were a tailwind to stocks, provided a much larger benefit than the extra percentage points of interest that bondholders are now earning. Nonetheless, the current situation is not all negative for investors.
Higher rates have another benefit. A key criticism of the Fed is that, in the past, it’s left interest rates too low for too long. A result was that on the eve of the Covid crisis in February 2020, the Fed’s benchmark rate was at just 1.5%. That left policymakers little room to maneuver and forced them to turn to what I’ve called the Tommy gun of monetary policy: a technique known as quantitative easing. If you’ve heard about the government “printing money,” that’s what quantitative easing is. It’s not a sound policy option, in my view, and if we can avoid it, we should. With rates at a higher level now, that leaves the Fed more room to lower rates in the future when it needs to, and thus avoid printing money. It’s a healthier place to be.
What does this all mean for investors? I don’t share Marks’s gloomy outlook, but this is a reminder to investors to be sure their portfolios are effectively diversified. On the stock side, higher interest rates are relatively better for value stocks—the shares of older, slower-growing and dividend-paying companies—than for growth stocks. So you’ll want to make sure your portfolio is balanced. While I’m an advocate for simple portfolio structures, this is an area where it’s worth a little extra work. That’s because, after years of outperformance, technology company stocks now dominate broad-based indexes like the S&P 500. According to data from Morningstar, growth stocks now outweigh their value peers by nearly two-to-one in the S&P 500. For that reason, I recommend supplementing the S&P 500 with a separate, smaller holding in a value index fund.
On the bond side, it’s also important to diversify. I recommend only government bonds, and only short- or intermediate-term issues. But even within those narrow categories, you’ll want to diversify, owning both conventional and inflation-protected bonds. That will help your overall portfolio hold up whether inflation continues to fall or we see a resurgence. Indeed, Treasury Inflation-Protected Securities (TIPS) are now pricing in just 2.2% inflation over the next 10 years. Should inflation continue at any level above that, TIPS investors would benefit.
A final note: If you are in your working years and a net saver, Marks’s downbeat forecast shouldn’t concern you. Indeed, young people should actually look forward to market downturns, because they’re an opportunity to pick up shares at lower prices.