Even when rates are higher, stocks should still beat bonds

If you're a long-term investor like most of us, you can relax after the Fed's rate hike.

Your best portfolio move in response to the Federal Reserve's rate-hike decision may be to do nothing different.

That's because the equity risk premium - the amount by which stocks outperform T-bills - is on average no lower when interest rates are higher. This is illustrated by the accompanying chart, courtesy of calculations provided by Wes Crill, a vice president at Dimensional Fund Advisers. As you can see, the S&P 500 SPX on average has produced nearly identical returns historically regardless of whether short-term Treasury rates are above or below the median. Crill said in an email that the difference between the two columns in the chart is not statistically significant.

The message of this chart makes theoretical sense. Because equities are riskier than fixed income, investors demand a higher expected return to incur that greater risk - regardless of where interest rates may stand. If stocks didn't offer that higher expected return, rational risk-average investors wouldn't invest in them.

To make sense of this theoretical point, it's important to distinguish between stocks' return while interest rates are rising, and their expected future returns. It is indeed the case that stocks on average perform poorly as interest rates are rising, as the present value of their futures earnings is discounted at higher and higher rates. One consequence of their negative reaction to rising rates, however, is that their expected future returns go up.

As Crill put it in an email, "all else equal, higher bond yields should lead to higher expected stock returns. In other words, the premium for stocks over bonds may not shrink just because of higher rates."

The investment implication of Crill's analysis depends on whether you are a long-term investor or a shorter-term stock-market timer. If you're in the former camp, you presumably have already chosen a stock-bond allocation based on your age, risk tolerance and other financial-planning considerations. If so, then the Fed's rate-hike decision this week provides no reason to alter your portfolio's asset allocation.

If you're a short-term stock-market timer, in contrast, the implication of Crill's analysis is that you need to first become a bond-market timer. You'd want to underweight stocks so long as you believe interest rates will continue rising, but overweight them once you think that a rate-cut cycle is about to begin.

That's asking a lot, however, since my auditing firm's tracking of market-timing newsletters finds that successful market timing is no easier with bonds than it is with stocks. Those who try to predict the trend of interest rates on average are wrong more than they're right.

That means that, for almost all of you, the appropriate reaction to this week's Fed's rate hike decision is to sit on your hands.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com

-Mark Hulbert