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If you’re new to investing or if you’re simply curious as to why us bloggers jabber on incessantly about the Federal Reserve and interest rates, it’s because it’s hard to overemphasize the importance of interest rates on equity valuations.

Understanding this fact is one of the most important keys to investing. Simply put, interest rates call the shots for the stock market. Not only do lower rates make it cheaper to rent someone else’ money, but it also provide stiffer competition for stock prices so shares tend to adjust higher. When rates rise, the opposite happens.

I’ll give you an example. I looked at all the data going back to 1962. I separated out each day that short-term T-bill rates fell. I then squished all those days together and found that combined, the S&P 500 rose over 2,000%. On days when rates rose—a nearly identical time frame—the S&P lost nearly 60%.

As impressive as that it, for long-term rates, the effect is even more dramatic. On days when the 10-year T-bond yield fell, the S&P soared 90,000%. Wow! On days when the yield climbed, the S&P 500 dropped nearly 99%. If we try to annualize that, assuming 253 trading days year, that means the S&P gains 42.3% a year when long-term rates fall and it loses 20.4% when long-term rates rise.

We can put those two variables together and see how the stock market reacts to the spread between short-term and long-term rates. Not surprisingly, stocks like a positive yield curve (when short rates are less than long). When the yield curve is positive (about 87% of the time), the S&P 500 gained 2,500%. When the yield curve is negative, stocks are down about 25%.

Here’s the kicker: All of the S&P 500’s price gains have come when the yield curve is positive by 67 or more basis points. Anything less than that, stocks have flat. Zippo.

One more thing. The current spread is about 45 basis points.

Posted by edelfenbein at September 18, 2007 1:24 PM