The past year has been a rollercoaster for investors. Concerns about persistently high inflation and the Federal Reserve’s aggressive rate hikes have rattled markets. The stock market, particularly tech-heavy sectors, has seen significant drawdowns, seemingly confirming the common belief that rising interest rates are bad for stocks.

But wait, there may be a twist. Historically the S&P 500 delivered a stronger average annual return of 14.5% when the 10-year Treasury yield was 6% or higher, compared to 7.7% when it was less than 4%.

The research also indicates stocks performed better during periods of rising interest rates, with an average annual rolling one-year return of 13.9%, as opposed to 6.5% in a falling rate environment.

What’s going on? Why is this so counterintuitive compared to what the market media have been screaming about for the last few years?

Remember, lower rates can often signal sluggish economic growth. The Fed cuts in the face of looming disaster and stays there until they’re 100% sure we’ve averted disaster.

As a result, higher rates may actually reflect a stronger economy and the prospect of better corporate earnings — factors that usually bode well for the stock market.

Navigating the Current Climate

Since April, bond yields have climbed, with the 10-year Treasury yield peaking near its highest level since November 2023. This coincided with a decline in the S&P 500.

In my view, this anticipates a “return to normalization” with yields eventually settling around their 75-year average of 5%. You read that right. Rather than being some toxic frontier, 5% is average. It’s normal.

And it’s really just about 2 percentage points above ambient inflation. If the Fed coaxes price pressure back down to its target, that translates to bond yields staying at or above 4%. 

So if  rising interest rates might not be the death knell for stocks, here’s what you should keep in mind:

• Economic Context is Key: Don’t just look at the rate itself, consider why it’s rising. A stronger economy and healthy earnings prospects can create long-term opportunities.
• Long Game: Don’t let short-term market swings derail your investment plans. A rise in rates, especially within a normalizing range, could fuel an eventual market upswing.
• Focus on Fundamentals: Interest rates are just one factor. Look for companies with strong earnings, good cash flow, and the ability to navigate higher borrowing costs.

By understanding the bigger picture and combining this perspective with your own analysis, we can make informed investment decisions, potentially beating the market in a surprising interest rate environment.