Why are stocks bought even when interest rates rise? The mechanism behind rising stock prices during rate hike cycles

What are the limits to continued stock price gains despite rising interest rates? Learning signals of stock price declines from past bubbles and markets

Changes in the stock market brought about by AI investment and soaring interest rates | Key points for investors to identify in a rate-hike market

1. Principles (Textbook Theory)

• Basic mechanism: When interest rates rise, the yields (investment returns) on safe assets like government bonds increase. Since the necessity of taking risks to buy stocks diminishes, it is generally considered that stock prices tend to fall.

• Corporate burden: Because interest rate hikes increase corporate borrowing costs (interest payment burdens), stocks are more likely to be sold off due to concerns about future earnings.

2. Reasons why stock prices rise even when interest rates rise

The main factors why the market does not move according to the textbook (rate hikes = stock price decline) are as follows.

1. Surpassing corporate growth speed (earning power)

   • If the growth in earning power and growth expectations of companies (recently, such as AI and semiconductor-related firms) overwhelmingly exceed the speed of the increase in interest payment burdens, stock prices will rise.

2. Substantially loose monetary conditions (inflation)

3. Theoretical models (Dividend Discount Model / Discount rate and growth rate)

   • Stock prices are determined by the balance between the “discount rate (interest rates, etc.)” and the “expected corporate growth rate.” If corporate performance and growth expectations outweigh the impact of the discount rate increase caused by rising interest rates, stock prices will rise (the upward scenario).

3. Specific examples from past historical phases

• 1994 (Surprise rate hikes and soft landing)

  • The FRB (Chairman Greenspan) suddenly implemented rate hikes to prevent the economy from overheating. Although the S&P 500 fell by 8% temporarily, stock prices recovered once confidence was gained that corporate earnings could be maintained even after the rate hikes (stock price increase due to soft landing expectations).

• 1999 (Dot-com bubble)

  • Even during the FRB’s rate hike phase, overwhelming growth expectations for the internet and IT (a state similar to the current AI boom) prevailed, and the S&P 500 rose by 15%, ignoring the rise in yields.

  • *However, after March 2000, when the backing of the real economy could no longer keep up, there was a significant decline of 49% over approximately two years.

• 2006 (Crude oil price hikes and inflationary pressure)

  • The FRB raised the policy interest rate to 5.25% in line with soaring crude oil prices. Even with interest rates at a high level, stock prices remained firm while responding to energy costs and other factors.

• 2016 (Trump rally and economic normalization)

  • An example where rising interest rates were perceived positively as a signal of breaking away from the low growth and low inflation following the Lehman Shock (economic normalization). Due to expectations for the Trump administration’s tax cuts, deregulation, and infrastructure investment, the S&P 500 rose by 12% under rising interest rates.

• 2022 (The opposite case: A historic sell-off market)

  • Due to the Fed’s delayed judgment in labeling post-pandemic inflation as “transitory,” rapid interest rate hikes were implemented (10-year Treasury yield rose from 1.7% to over 4.25%). Stocks and bonds fell simultaneously, and the S&P 500 dropped by up to 25% (a period when the traditional “60/40” stock-bond diversified portfolio did not function).

4. Recent (current) market structure and points to watch going forward

Current structure (AI boom and hyperscalers)

• Massive AI investment: Major IT companies (hyperscalers) are investing huge amounts of capital into data centers, semiconductors, and power infrastructure, maintaining extremely high corporate profitability.

• Competition for capital: Private demand for AI investment is competing with U.S. government deficit financing, pushing up interest rates by increasing the term premium. In other words, the current rise in interest rates has an aspect of being a “byproduct of robust economic activity and investment demand.”

Risk factors and checkpoints for a shift to stock price adjustment (decline)

Although stock prices are rising even amidst high interest rates, this will not last forever, and there are limit points. Attention must be paid to the following risks.

1. Disappearance of the Equity Risk Premium (ERP)

   • The risk that when Treasury yields become sufficiently high, investors will come to their senses, thinking “I don’t need to take risks to hold stocks if I can just hold Treasuries,” leading to a flight of capital into safe assets.

2. Downward revisions in earnings and investment recovery rates for major IT (hyperscalers)

3. Uncertainty regarding the goal (peak) of interest rate hikes

   • If a state of “not knowing how high interest rates will go” arises due to factors like the stickiness of inflation, stock price valuations (multiples) will contract, and market recalculation and adjustment will occur.

4. Crude oil prices and geopolitical risks (such as the situation in Iran)

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