Bears take little interest in the rates

British interest rates have risen steadily since touching 3.5 per cent last year, a 48-year low. They currently stand at 4.5 per cent, after four one-quarter point hikes in the past seven months. Experts debate when the next rate rise will occur and the size of it. But all agree that further rate hikes are in the pipeline.

It is widely believed that rising rates and stock market downturns march hand-in-hand. Viewed from this perspective, the bull market in shares that has been under way since March 2003 might soon end - if it has not already run its course.

Happily, the facts tell a dif ferent tale. UK investors have suffered 13 separate stock market downturns since the mid-1960s. Several were quite mild, running for a few months and pulling prices down by as little as 15 or 20 per cent. Others were more painful. The bear market of 2000-2003 saw shares decline by 51 per cent. The granddaddy of all downturns, in 1972-4, reduced the typical portfolio by 74 per cent.

But shares usually began to drop before rates began to rise. A good example was 1972. Inflation was rising throughout the western world. Here, investors also had to worry about the effect of high unem ployment, continuing labour disputes, a deteriorating currency and the ineffectiveness of the Conservative government of the day. The stock market peaked on 1 May, almost two months before the government began to raise interest rates.

The same thing occurred in 1987. Shares peaked in July and rates were raised by 1 per cent the following month. The market fell by just 3 per cent in the next two trading days before starting to briefly rebound. With the benefit of hindsight, it is now apparent the real problems for investors were economic problems such as dramatic increases in our trade deficit and excessive speculation triggered by too much liquidity in the financial system.

Those with a long memory will recall that Blue Arrow, a small recruitment agency, was able to finance a takeover bid for the giant Manpower, about 40 times its size. At the same time, Martin Sorrell's WPP launched a £177 million rights issue to acquire advertising giant J Walter Thompson.

Many other bear markets in the past four decades followed a similar road map. Investors sensed a developing economic problem and began to sell. In all likelihood, they were reacting to the same warning bells that concerned the monetary authorities. But they typically began to sell before the authorities took action.

The steady pattern of stock market weakness prior to the start of a rise in the interest rate cycle makes an important point about the world of investing. Many investors believe share prices ebb and flow in step with interest rates. But they typically react to prospects for economic growth. The direction of the interest rate trend is merely one of many signals that help investors to gauge future profit prospects. If prospects are favourable, history teaches that investors will try to capture some of those rising profits by purchasing shares, even if rates are rising. Conversely, if economic prospects are weak, investors are likely to sell or hold back from buying shares, regardless of the direction of the interest-rate cycle.

There were only three exceptions to the rule. The stock market fell by 22 per cent in January to September 1990. The downturn began after an interest rate up-cycle had already begun. However, that cycle was very atypical. Rates were hiked from 8 to a whopping 15 per cent in 13 separate rises over an 18-month period before the stock market finally began to fall.

A similar pattern unfolded in the run-up to the 1998 bear market. Shares fell 25 per cent in three months, after an interest rate up-cycle had begun. Once again, rates began to rise in October 1996, almost two years before shares turned down.Seven hikes were recorded before the stock market cracked.

In addition, many experts believe the 1998 bear market had little to do with our domestic economy. A little-known hedge fund named Long-Term Capital Management suddenly went bust.

Investors were stunned to learn that its debts might be massive enough to threaten the survival of several major international banks and the borrowing ability of many other companies. Soon after, Russia defaulted on debts to Western lenders. Argentina then joined the party with another bout of fiscal irresponsibility. It was this combination of events outside our control that caused shares to drop, not interest rates.

The third exception was the bear market of 2000 to 2003, when shares fell 51 per cent. British interest rates had already risen in four separate quarter-point moves when the FTSE All Shares peaked in September. Did interest rates cause the sell-off? If so, it would be the only one of 13 recent bear markets solely triggered by rising interest rates. But the downturn followed one of the greatest stock market bubbles in history. Shares were significantly overvalued.

On balance, the mass of objective evidence provides little support for those who worry that rate rises in the near future will trigger the next bear market. Prospects of interest rate rises in the near future are more likely to be a positive sign for shares, not a negative one.

Some investors may think this time could be different because of events in the US. The list of potential problems across the Atlantic is frightening: massive budget deficits, a weak currency, serious import-export imbalances and a dangerous taxing and spending programme.

Might these issues trigger a rerun of 1998 or 2000-2003? Probably not, for one important reason. Stock markets react to fresh information; the US problems are widely known, and most probably already in the price.