The Market's Secret Defense Against Higher Rates

The conventional wisdom heading into this earnings season held that higher interest rates would eventually overwhelm equities. Keith Buchanan, CFA, Portfolio Manager at Globalt Investments, challenges that framing directly¹. Rates are doing exactly what they should do, Buchanan argues. The surprise is what has stepped in to absorb the damage.

Rates Are Working. Earnings Are Compensating.

The textbook relationship between interest rates and equity valuations has not broken down. What has changed is the force offsetting it. "Higher rates have not been irrelevant to the equity market," Buchanan states. "They have shown up through lower valuation multiples." The forward price-to-earnings multiple on the S&P 500 declined from 20.4x at the end of the second quarter to 19.2x as of September 25, a compression that reflects precisely the discount-rate mechanics every finance student learns. Higher required rates of return raise the denominator in any discounted cash flow model, lowering the present value of future earnings. That part has been working as expected.

What has not followed the script is earnings. Since June 30, the S&P 500's forward 12-month EPS estimate climbed 8.9%, while the index itself rose only 2.7%. Buchanan frames this arithmetic plainly: "The reason stock prices have continued to rise is that earnings growth has been strong enough to more than offset the pressure from lower valuation multiples." FactSet estimates third-quarter S&P 500 earnings growth at 29.1% year over year, up from a 26.7% estimate at the start of the quarter. If that figure holds, it would mark a third consecutive quarter of earnings growth above 25% and an eighth consecutive quarter of double-digit growth.

The Earnings Cushion

Buchanan introduces a useful organizing concept: the earnings cushion. "As long as earnings continue to grow faster than valuation multiples contract, stock prices can still move higher." The analogy he offers is concrete: if earnings rise 15% while the multiple investors are willing to pay falls 5%, the market still produces a positive return. That tug-of-war, he notes, is effectively what is playing out today.

The question that follows is durability. FactSet projects full-year 2026 S&P 500 earnings growth at 32.0%, with Q4 coming in at 26.8%. Analysts currently expect a moderation to 15.4% growth in 2027. That deceleration is not a crisis signal, but it narrows the margin available to absorb further multiple compression.

The Valuation Ceiling That Isn't Quite a Ceiling

Even after meaningful multiple compression, the market is not cheap. The S&P 500 trades near 19x forward earnings. The Nasdaq 100 and Russell 2000 sit at approximately 23x and 24x, respectively. Several major benchmarks remain above their 20-year median valuations. Buchanan is careful here: "That does not mean the market is destined to fall. Historical valuation averages are not hard ceilings, and valuation is not a particularly reliable short-term timing tool." What it does mean, he argues, is that "the margin for error may be smaller than the headline strength in the market would suggest."

Three Scenarios, One Key Variable

Buchanan maps three possible paths from here. If rates fall and earnings keep growing, the market benefits from multiple expansion and earnings momentum simultaneously. If rates stay elevated but earnings remain strong, the current environment persists. The third scenario is the one worth watching: "The more difficult outcome would be one in which rates remain high while earnings growth begins to slow. In that scenario, the cushion starts to disappear."

The closing line of the piece is as clean a summary as market commentary gets: "Higher rates have already taken something away from valuations. Earnings have given it back. The question is whether they can keep doing it."

5 Key Takeaways for Advisors and Investors

1. Rates and valuations are behaving as expected. Multiple compression from 20.4x to 19.2x is not a market failure. It is the discount-rate mechanism functioning correctly.
2. Earnings are the swing factor. An 8.9% rise in forward EPS since June 30 has more than offset the valuation drag. Earnings are carrying the market right now.
3. The earnings cushion is real but conditional. It holds only as long as earnings growth outpaces multiple contraction. Watch earnings revisions closely as 2027 guidance emerges.
4. Stretched valuations mean less room for error. Trading above 20-year medians is not a sell signal, but it does compress the buffer available to absorb bad news on either rates or growth.
5. The 2027 moderation is the central risk. Analysts already expect earnings growth to slow to 15.4% next year. If that deceleration arrives alongside rates that remain elevated, the current tug-of-war shifts decisively.

Footnote:

Buchanan, Keith. "Why Higher Rates Haven't Broken the Stock Market." Globalt Investments, 1 Oct. 2026, https://static1.squarespace.com/static/6691650f7cf3cc0e81616f61/t/6ac59481ccd6b6274bdf681b/1791333505779/100126+Why+Higher+Rates+Haven%27t+Broken+the+Stock+Market.pdf.