Interest rates rose last week, but the surge did not keep stocks from climbing. Russ explains why.

Last week stocks edged higher: The S&P 500 rose approximately 1%, while small caps and value stocks had a particularly good week. A stronger stock market is no longer news, but what was interesting was that stocks rose even as interest rates surged higher.

If lower rates have supported the rally, why did higher rates not derail it? The simple reason: At these levels, modestly higher rates don’t threaten equity valuations, especially if higher rates are a function of firmer economic expectations.

Not a straight line

The conventional wisdom is that lower rates are good for equities. This follows from basic economic theory: The lower the discount rate, the higher the value of an asset. Over the long term this relationship is supported by the data; investors have typically paid more for stocks (in the form of higher price-to-earnings (P/E) multiples) when rates are lower. That said, there is a caveat: The relationship breaks down when rates get very low, as they have been for more than a decade.

While a simple linear-regression using bond yields explains about 30% of the variation in the P/E multiple of the S&P 500, a non-linear model does even better. When bond yields fall below 4 or 5%, the relationship between yields and earnings multiples becomes less linear (see Chart 1). A simple explanation is that extremely low interest rates are associated with recession fears. When this happens, as it did in 2009 and 2012, low rates are generally associated with lower valuations.

As last week’s backup in rates still left yields at historically low levels, higher rates should not threaten the rally. In fact, higher rates may actually be supportive of certain segments of markets, most notably financials. To the extent higher rates are being driven by better growth prospects, this also supports the broader value space, as witnessed last week.