A reader asks:
I don’t work in finance but I know enough math to get me into trouble (I’m an engineer). All else equal, a higher discount rate should mean a lower present value of future cash flows. I know all is not always equal but with rates rising again and the prospect of higher for longer now firmly on the table, shouldn’t that be a headwind for stocks? What am I missing here?
Good question.
Finance theory does state that the present value of an asset is the future stream of cash flows discounted by a reasonable rate of interest.
If PV = CFs / (1+rate)time and the rate goes up, all else equal, the present value should go down.
The problem with this line of thinking is there is a huge difference between theory and reality. Plus, all is rarely ever equal.
After rising at a fast clip last fall, interest rates dipped but they are now going back up again:
The spread between the short and long ends of the curve is compressing.
This should be bad for the stock market, right?
Yes, in theory, but the historical track record suggests rising interest rates are not the end of the world for the stock market.
In fact, the S&P 500 has done just fine during rising interest rate cycles in the past. I’ve written about the stock market vs. rising rates in the past:
From 1950 through the pre-pandemic era, the average annualized return when the 10 year yield jumped 1% or more, was just shy of 11%. That’s basically the long-term average performance for the U.S. stock market. It was only down twice when this happened and the losses were minimal.
That’s rising rates but how does the actual level of rates impact future
