Money Compass

By Kyle Tetting

Earnings and interest rates. As I explained recent weakness in markets with some very patient clients in my office, those words brought me back to reality.

I’d spent a few minutes opining on the actions of the Federal Reserve, the prospects of recession and the pressures of inflation. When I had finished my dissertation, my clients asked a simple question: “What are those two things Bob always told us mattered?”

The right questions are better than the correct answer. Their question reminded me of what truly drives stocks in the long run. Short-term – and sometimes that short-term feels like an eternity – stocks can behave irrationally. Stock prices are subject to all kinds of emotional response. Stocks sell off on the prospect of recession or trade higher on the prospect of an economic reopening. Those are powerful forces, but they tell the story of now, and we don’t buy stocks for today.

Instead, we buy stocks we believe have something to add as we look into the future. It’s reflected in the very way we try to value stocks, discounting our expectations for future earnings. It isn’t about what happens today, it’s about where we think stocks are headed and what the alternatives to those stocks might be. In other words: Earnings and interest rates.

The most significant challenge to stocks today is the interest rate component. We spent the better part of 10 years after the financial crisis talking about earnings. With interest rates at or near zero for most of that time, earnings just mattered more. But as rates have risen, interest rates have reentered the conversation. Future earnings just aren’t worth as much when the alternatives to stocks – like a better rate on bonds – begin to look more attractive.

More articles and videos from Kyle Tetting on Money Talk

But changing interest rates also impact the price of bonds, not just stocks. As interest rates have risen, pre-existing bonds issued when rates were lower look less attractive than new bonds, and prices fall. The resulting selloff has been significant, both because of how low rates were and just how quickly they’ve risen.

However, after a decade where stocks did the heavy lifting of portfolio returns and bonds offered little because of low rates, the math is finally starting to shift. The pain of higher rates on bond prices has made them more attractive, not less, as investors can now expect a bit more interest from their bonds.

The Federal Reserve has made clear that the path forward is likely to include additional increases in the overnight rate. That will, undoubtedly, lead to more questions, though it’s now clear the benefit of near-term pain is long-term gain. Higher return expectations from our bonds should reduce the emphasis we’ve had to place on stocks since the financial crisis. In other words, a little volatility now should help to smooth the bumps down the road.

There are, of course, plenty of challenges that remain beyond simply the Fed’s intended path for interest rates. It’s why, despite reasonable expectations in any one direction, we don’t abandon balance. Instead, we should continue to plan appropriately for any short-term needs and trust that the appropriate balance will help navigate the uncertainty that always lies ahead.

Kyle Tetting is president of Landaas & Company. 

Learn more
Fed needs tools, time, incremental tuning, by Kyle Tetting
How bonds fared as Fed has raised rates, a 2016 Money Talk Video with Kyle Tetting
The importance of balance, a Money Talk Video
Beginners Guide to Asset Allocation, Diversification and Rebalancingfrom the U.S. Securities and Exchange Commission
(initially posted April 29, 2022)

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