How Stocks Behave In Different Interest Rate Environments

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

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At the beginning of every month, I brief members on how MoneyGeek's Regular portfolios have performed and comment on the state of the financial markets. In this update, Ill also comment on how the stock market has historically behaved during rising interest rate environments.

November Performance of Regular Portfolios

The performance of MoneyGeek's Regular portfolios for the month of November 2018 were as follows:

I've chosen to list below the performance of some of our competitors. For the sake of brevity, I've decided to show only those portfolios that have a similar risk profile to MoneyGeek's Regular Aggressive portfolio.

In contrast with our competitors, MoneyGeeks Regular portfolios employ stocks/ETFs that follow the value investing strategy (QVAL, IVAL and BRK-B), and also allocate a larger percentage of the portfolios toward Canadian oil and gas stocks (XEG.TO) and gold (CGL-C.TO). If you would like to take a look at our portfolios, I invite you to sign up for our free membership.

In November, Regular portfolios underperformed the competitors. While BRK-B outperformed the US stock market because of a positive quarterly earnings report, XEG.TO dragged the portfolio down because of the well publicized challenges that Canadian oil companies are facing.

Investors are so pessimistic about Canadian oil companies that XEG.TO is currently some 30% below the level it was at in 2009. The average P/E (Price to Earnings) ratio of companies in XEG.TO is less than 3, which is astoundingly cheap. To put this in perspective, the average P/E ratio of US companies is about 21, which suggests that by this (admittedly simplistic) metric, Canadian oil companies are some 7 times cheaper than the average US stock.

You may wonder why oil stocks can get so cheap, while stocks in other industries can get so expensive. Marijuana stock Tilray, for instance, is still valued at $9 billion today despite recording losses on top of very modest revenues. While I dont have all the answers, I believe that the recent rise in interest rates offers us a clue.

As the chart below illustrates, stocks with high momentum (i.e. stocks whose prices had consistently gone up) have tended to do well in the US during rising rate environments. Stocks such as Tilray are in that category.

Its difficult to ascertain reasons why momentum stocks have performed well in rising rate environments in the US, particularly when the same phenomena doesnt appear to repeat itself in the UK. Nevertheless, I believe a rising rate environment does influence momentum stocks in some fundamental way, given that the performance is so much higher than during falling rate environments.

In contrast, we have a fairly good understanding of why value and income stocks do well in falling rate environments. Interest rates tend to fall when the economy is not doing well, so investors tend to flock to boring companies with stable cash flows. Also, stocks have rough price floors, below which it becomes too cheap for other companies to ignore. Such stocks tend to receive buyout offers, which then drives up their prices.

The current period of rising interest rates began in 2015, when the economy started growing very strongly. However, the period of rising rates might have come to an end. The economic outlook has weakened in recent months, and the stock market has been rather volatile, which suggests that investors are becoming anxious. The US Federal Reserve tends to lower interest rates during such times, and investors are becoming more convinced that rates wont rise in 2019.

If the economy does weaken and interest rates fall, then if history is any guide, momentum stocks such as Tilray and certain technology stocks will fall harder than value stocks such as Canadian oil stocks. Since MoneyGeeks portfolios are heavily weighted towards value stocks, they should do better than their competitors in such an environment, in theory.

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.