Interest Rates and the S&P 500

Interest Rates

The inverse correlation between stocks and interest rates is strong. Stocks tend to perform best when interest rates are falling and to struggle or fall during periods of rising interest rates. The critical questions are which interest rates to use and how to measure them (nominally? versus their value a year ago? 6 months ago? versus their moving average?) Historically, all interest rate series show a strong, stepwise inverse relationship with subsequent S&P 500 performance.

30 Year Bond Yield 12 Month Percentage Change

Perhaps the simplest way to measure a change in interest rates is to calculate a year over year percentage change. If we perform this calculation on the longest term interest rate (the 30 year bond yield) and compare how S&P500 performs over the next 12 months, the results are impressive:

12 month change in the 30 year Treasury bond yield versus next 12 month change in the S&P 500 , January, 1945-May, 2007, n = 726:
		Year over year change in the 30 year Treasury bond yield:		Next 12 month change in the S&P 500:
Percentiles:	n	From:	To:
Min-25%	182	-33.54%	-6.22%	12.14%
25-50%	182	-6.22%	2.32%	8.93%
50-75%	180	2.32%	9.84%	7.61%
75-Max	182	9.84%	40.47%	6.17%
		Correlation:		-15.3%
All:	726		Average:	8.70%

A clear, step-wise inverse correlation is seen. Every stratum of decreasing Treasury bond yield percentage changes has a higher average subsequent 12 month change in the S&P500. The S&P 500 perform best during periods of falling Treasury bond yields, rising 12.14% on average when the yield today was 6.22% lower than it was a year ago. If the yield rose by greater than 9.84%, the market rose only 6.17% on average. Note that this percentage drop is a ratio, not a difference, meaning that a change from 4 to 6% would be a 50% - not a 2% -increase.

Note also that only in years in which the yield rose less than 2.32% did the market rise more than its average 8.70% overall average. Only in years of falling yields did the S&P 500 rise by more than 10%.

90 Day Treasury Bill Yield 12 Month Percentage Change

Performing a similar analysis using the 90 day Treasury bill yield produces similar results:

90 Day Treasury Bill Yield change, year-over-year, versus next 12 month change in the S&P 500 , January, 1946-May, 2007, n = 707:
		Earnings yield			Next 12 month change in the S&P 500:
Percentiles:	n	From:		To:
Min-25%	177	-73.49%		-16.64%	13.28%
25-50%	176	-16.64%		6.69%	12.76%
50-75%	177	6.69%		28.14%	5.49%
75-Max	177	28.14%		269.32%	4.80%
		Correlation:			-21.2%
All:	707		Average:			9.08%

Notice once again a strong, stepwise increase. The market performed poorly (4.8% average 12-month change) when the 90 day yield was 28% higher than a year ago, and best when it was falling, or at least rising less than 6.7%.