Market Signals: Fed Decision Makers Brace for Pain in Stocks and Real Estate

The belief that stock prices fall when interest rates rise is widely held but rarely examined. However, historical data shows a strong correlation between interest rates and inflation. Higher inflation typically leads to faster nominal corporate earnings growth, but investors tend to focus more on the negative impact of a higher discount rate. This behavioral bias, known as "inflation illusion," causes investors to undervalue stocks during periods of high inflation. Conversely, when inflation and interest rates start to decline, investors are likely to make the opposite error, creating the foundation for a major buy signal in the stock market.