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November 2021

Expect the Unexpected


As we start to think about 2022, it can be helpful to reflect on what we accomplished over the past year. What happened that we expected, and what surprised us?

Despite inherent limitations, looking to the past can help guide our expectations as we set goals and plan for what we are certain will occur. As time moves forward and we receive new information, we should adjust accordingly.

We can apply the same logic to investments and a lot of market data in general. After all, stock prices and interest rates are forward looking. They embed the collective expectations of market participants about the prospects of individual companies, sectors and economies. With news comes additional information that can impact our assumptions about the future—the latest COVID-19 variant first detected in South Africa, for example.

Buying and selling activity around new information can be perfectly sensible, just as using the past to help inform our expectations about the future can be sensible. But the future holds a high level of uncertainty, a fact we should all keep top of mind as we evaluate predictions and forecasts.

Let’s consider the example of interest rate levels and what rising rates likely signal for future stock returns. Over the last 12 months, interest rates in the U.S. have increased, with most increases happening in spring 2021.

Figure 1 shows the interest rates for U.S. Treasuries of various maturities. Rates as short term as one year, out to 10 and even 30 years have increased. Intermediate-term rates (five to 10 years) have increased more than other segments of the yield curve.

Figure 1 | U.S. Treasury Rates Have Risen Over the Past Year

Maturity (Years)

11/26/2021 (%)

11/26/2020 (%)

Change

1

0.17

0.11

0.06

2

0.50

0.16

0.34

3

0.80

0.21

0.59

5

1.17

0.40

0.77

7

1.40

0.65

0.75

10

1.49

0.88

0.61

20

1.90

1.41

0.49

30

1.84

1.63

0.21

Data as of 11/26/2021. Source: Bloomberg.

Figure 2 | Despite Recent Increases, Interest Rates Are Still Low

Despite Recent Increases, Interest Rates Are Still Low

Data from 1/1/1971 – 9/30/2021. Sources: FRED, Federal Reserve Bank of St. Louis and U.S. Bureau of Labor Statistics, Avantis Investors.

Don’t Mistake the Noise for a Signal

So, if we want to try to use interest rates to inform our expectations about future stock returns, the first question is whether interest rates today, or recent changes in interest rates, tell us anything about interest rates in the future. Why? If the “signal” we are using to inform our actions is really noisy, how can we be sure that it gives us a true signal, not just noise?

Figure 3 shows the relationship between the 10-year Treasury yield 12 months ago (horizontal axis) and interest rates today (vertical axis). The nearly one-to-one slope of the line illustrates the strength of the relationship. We observe that interest rate levels from a year ago tell us a lot about interest rate levels today. Even though it is not a perfect match, today’s interest rates tell us a lot about future interest rates.

What if we look at the relationship between recent changes in interest rates versus future changes in interest rates? Figure 4 plots the prior six-month change in the 10-year Treasury yield against the subsequent 12-month change. In other words, each value on the horizontal axis represents the change in interest rates from March through September of each year, while the vertical axis plots the subsequent change from October to the following September.

Relative to Figure 3, where the dots fall in a clear pattern, here we see no discernable pattern. The dots look more like a cloud than a straight line. Basically, the change in interest rates over the last six months doesn’t tell us much about what will happen with interest rates over the next year. “Expected” changes probably already happened, while unexpected changes yet to occur are randomly distributed.

Figure 3 | Current Yields Have Information About Future Yields

Current Yields Have Information About Future Yields

Data from 9/30/1970 – 9/30/2021. Sources: FRED, Federal Reserve Bank of St. Louis and U.S. Bureau of Labor Statistics, Avantis Investors. Past performance is no guarantee of future results.

Figure 4 | Recent Changes in Yield Don’t Tell Us Much About Future Changes

Recent Changes in Yield Don’t Tell Us Much About Future Changes

Data from 9/30/1970 – 9/30/2021. Sources: FRED, Federal Reserve Bank of St. Louis and U.S. Bureau of Labor Statistics, Avantis Investors. Past performance is no guarantee of future results.

So, the level of interest rates today can tell us something about the level of interest rates in the future. But any recent change in interest rates tells us much less about future changes in interest rates. To return to the question at the beginning of our experiment—Can recent changes in interest rates tell us anything about future stock returns?

Figure 5 plots the same series of prior six-month changes in interest rates on the horizontal axis as Figure 4 but replaces the subsequent 12-month change in interest rates with the 12-month U.S. stock return. Like in Figure 4, the data resembles a cloud more than anything else.

To put some of this data into perspective, we have observed about a 60-basis point increase in 10-year Treasury yields over the last year, or a little more than 0.5%. The range of subsequent 12-month U.S. stock market returns following interest rate increases of about 0.5% is considerable, anywhere from approximately -5% to +40%. Like our observations in Figure 4, it seems that recent changes in interest rates do not provide much information about future stock returns.

Figure 5 | Changes in Yields Don't Provide Much Information About Future Stock Returns

Changes in Yields Don’t Provide Much Information About Future Stock Returns

Data from 9/30/1970 – 9/30/2021. Sources: FRED, Federal Reserve Bank of St. Louis and U.S. Bureau of Labor Statistics, Avantis Investors. The U.S. stock market is represented by the CRSP Total Market Index. Past performance is no guarantee of future results.

Perhaps, however, the U.S. stock market is too broad. Much of the discussion around prevailing interest rates and their impact on returns center around styles (e.g., value vs. growth) or sectors.

In Figure 6, we zero in on two sectors—Finance and Technology. While value and growth indices tend to have exposure to both sectors, the conventional wisdom is that growth-oriented stocks, like many technology stocks, are far more susceptible to changes in interest rates because more of their “value” is a function of their discounted cashflows. Any increase in discount rates applied to these cash flows would mean a hit to the perceived value (i.e., price) of the shares today.

What happens when we compare the returns of these two sectors in rising vs. falling interest rates? Figure 6 offers us that picture, illustrating the same prior six-month changes in the 10-Year U.S. Treasury yield as Figures 4 and 5, but now plotting the subsequent 12-month return for each industry group.

Once again, the data appear more cloudlike than anything else, with no clear pattern about whether Finance wins in rising interest rates or Technology wins in falling interest rates. This isn’t to say the conventional wisdom lacks logic—just that what we can observe in the data is far from conclusive.

Figure 6 | Changes in Yields Don’t Point to A Clear Sector Winner Either

Changes in Yields Don’t Point to A Clear Sector Winner Either

Data from 9/30/1970 – 9/30/2021. Sources: FRED, Federal Reserve Bank of St. Louis and U.S. Bureau of Labor Statistics, Avantis Investors. Finance and technology portfolios are from Ken French’s Data Library based on Compustat definitions for industry groupings. Past performance is no guarantee of future results.

Data Isn’t Always Conclusive

And that is probably the most critical point to remember when reading headlines and listening to prognostications from people who try to infer more than what the data can say. It doesn’t mean we can’t glean new information relevant to our investments, but we should take a lot of these statements with the oft-mentioned grain of salt.

The prevailing interest rate environment may require you to adjust your portfolio. We believe any rebalancing should be done in consultation with a trusted advisor who can make the evaluation within the context of your full financial plan and explain how your current allocation may (or may not) need to be adjusted.


Glossary

Basis Points. Basis points are used in financial literature to express values that are carried out to two decimal places (hundredths of a percentage point), particularly ratios, such as yields, fees, and returns. Basis points describe values that are typically on the right side of the decimal point--one basis point equals one one-hundredth of a percentage point (0.01%). So 25 basis points equals 0.25%, and 50 basis points equals 0.50%. Only when basis points equal or exceed 100 does the value move to the left of the decimal point--100 basis points equals 1.00%, 500 basis points equals 5.00%, etc.

CRSP Total Stock Market Index. Comprised of nearly 4,000 constituents across mega, large, small and micro capitalizations, representing nearly 100% of the U.S. investable equity market.

Expected Return. Valuation theory shows that the expected return of a stock is a function of its current price, its book equity (assets minus liabilities) and expected future profits, and that the expected return of a bond is a function of its current yield and its expected capital appreciation (depreciation). We use information in current market prices and company financials to identify differences in expected returns among securities, seeking to overweight securities with higher expected returns based on this current market information. Actual returns may be different than expected returns, and there is no guarantee that the strategy will be successful.

Standard deviation. A statistical measurement of variations from the average. In finance, it's often used to measure volatility and risk. In general, a higher standard deviation means more volatility and more risk.

Treasury Yield. The yield (defined below) of a Treasury security (most often refers to U.S. Treasury securities issued by the U.S. government).

Yield Curve. A line graph showing the yields of fixed income securities from a single sector (such as Treasuries or municipals), but from a range of different maturities (typically three months to 30 years), at a single point in time (often at month-, quarter- or year-end). Maturities are plotted on the x-axis of the graph, and yields are plotted on the y-axis. The resulting line is a key bond market benchmark and a leading economic indicator.


 
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.

Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

Diversification does not assure a profit nor does it protect against loss of principal.

It is not possible to invest directly in an index.