Which of the figures in Exhibit 1 belong together?
Even if puzzles aren’t your strong suit, it’s not hard to observe that A and C are similar, as are B and D. A and C are not like B and D.
Exhibit 1’s puzzle is rooted in recent economic news, specifically in the consensus view that high inflation will lead to a sustained rise in interest rates. Whenever the prospect of rising rates looms, there is understandable concern over the reaction of the equity market. Conventional wisdom has been that rising interest rates should be bad for the stock market. But recent history has shown that that’s not necessarily the case. From 1991 through 2021, there have been 156 months when the 10-Year U.S. Treasury Yield rose. Of these, the S&P 500® gained in 115 (74%) of the months and declined in 41—i.e., in a rising rate environment, the market was more than twice as likely to do well as badly. The common belief that there is an inverse relationship between interest rates and equity market performance is no longer a sure thing.
By extension, the question of rising rates’ impact on factor indices also arises. Circling back to Exhibit 1, here’s the same graph, this time with some labels.
Consider the first grouping of three bars. These data tell us that in months when interest rates fell and the equity market also fell, the S&P 500 declined by an average of 3.8%%. The average outperformance of the S&P 500 Low Volatility Index was 2.3% in those months, while the average underperformance of the S&P 500 High Beta Index was 4.0%.
For strategies that are explicitly risk attenuators (like Low Volatility) or risk amplifiers (like High Beta), the condition of the equity market is much more important than the state of the bond market. For example, Low Volatility tends to outperform in bad markets while lagging in good markets, and High Beta tends to exhibit the opposite pattern of returns, regardless of whether interest rates are rising or falling.
As Exhibit 2 shows, the average return spreads of Low Volatility were positive in the months when the S&P 500 was down and negative in the months when the S&P 500 was up—and vice versa for High Beta. This dependency on the broader equity market was consistent regardless of the direction of the bond market.The posts on this blog are opinions, not advice. Please read our Disclaimers.