The U.S. stock market doesn’t deserve to fall as much as it has because of higher interest rates alone — and soon investors will begin to act on this realization.
The first step in a re-examination is to remind ourselves that interest rates and inflation are highly correlated. This has been true historically, as you can see from the accompanying chart. The interest-rate/inflation correlation is crucial, because nominal corporate earnings grow faster when inflation is higher. That doesn’t mean investors should welcome inflation, since higher inflation also means that future years’ earnings must be discounted at a higher rate.
Economists refer to this investor error as “inflation illusion.” Perhaps the seminal study documenting how this error impacts the stock market was conducted by Jay Ritter of the University of Florida and Richard Warr of North Carolina State University. They found that investors systematically undervalue stocks in the presence of high inflation.