The theory

From a theoretical perspective there are a number of valid reasons why interest rates have a direct bearing on stock markets, says Adrian Clayton, of Alphen Asset Management.

These can be summarised as follows:

1. Reducing business activity - interest rate management is the primary tool utilised by central banks across the planet to stimulate or curtail economic activity. 

The monetary transmission mechanism is broadly depicted as monetary conditions created by a central bank, affecting firstly, asset prices thereafter economic activity and finally the price of goods and services.

Changes in interest rates thus have a major bearing on levels of business activity and in turn corporate profitability.

2. Increasing or decreasing the discount rate - rapidly fluctuating short-term interest rates can have a bearing on the risk free rate, which is used by analysts to determine the current value of future corporate profits. 

Thus, changing interest rates positively or negatively affects the net present value of future monies received, which are in turn incorporated in the prices of a shares.

3. Relative asset values - higher interest rates result in yield bearing securities bearing higher yields, this against equities, where dividends are often negatively affected by increasing interest rates. 

Thus, in periods of high interest rates, it is not uncommon to see switching between asset classes occurring, with investors finding 'value' in money market and interest bearing capital instruments.    

But that's all the theory - what about the practical experience of rising interest rates? 

Well, we know that history has been definitive on this subject in certain instances, for example the Bank of Japan raising rates in the late 1980's which resulted in one asset bubble after another bursting. 

This was evidenced in the Nikkei which collapsed from 38 918 on 29 December 1989 and finally hit its low 7607 on 28 April 2003. 

What seems apparent from history is that it is all a function of the prevailing economic environment that actually determines the direction that a market takes in response to interest rate changes. 

What I am implying is that the market reads interest rate movements in different ways and rising rate cycles do not necessarily imply declining markets.  What does seem definitive, however, is that in highly overheated bubble-like scenarios, an interest rate hike is equivalent to a pin pricking an inflated balloon.

What follows is a quick scan of the behaviour of the US markets in response to changing interest rate cycles:

1. In 1971, the market lost up to 10% when the Fed raised rates.

2. In 1977, the market also lost similar amounts during that rate rising cycle.

3. From 1986, the markets rocketed 30% to May 1989 after the Fed raised rates 4%, this despite the 1987 crash.

Invesco undertook some interesting research on rate cycles over the past 40 years - there have been six of them. 

Their findings reveal that:

1. On average, in all the six rate cycles, share prices tended to ebb sideways during the first six months after rates changed direction.

2. Market participants are very in tune with the Fed and thus negative market movements often occurred before the rates actually changed.

3. On average markets tended to recover after six months from the first rate rise.

4. 5 out of 6 times, equity investors were in the money by the end of the rate rising cycle.

5. The negative return was recorded during the oil crisis in 1973/1974.

6. The average equity return during the increasing cycles was 5.2%.

What seems most apparent from this analysis is that the market is highly efficient with respect to Fed interest rate decisions and action often happens prior to the event. 

What is also evident, however, is the importance of being aware of the investing environment, in bubble times; interest rates can have scalpel-like consequences for markets as was demonstrated in the late 1980's with the Nikkei and again in March 2000, with the NASDAQ.