What will happen to the stock market when higher interest rates finally arrive? Recent history shows a short-term dip and then an uptrend. After that, other economic forces take over to steer the market.
While the mid-June meeting of the Federal Reserve’s policymaking committee looms, hardly anyone expects them to push up interest rates then. But hikes are surely coming.
When we look back at the last three Fed rate high cycles, the elevated volatility and current negative short-term trend are not a surprise. Shown below are the fed funds rate (what overnight bank lending rate, which has an impact on short-term rates generally), the Standard & Poor’s 500 and the 10-year U.S. Treasury rate during the rate hike cycles of 1994-1995, 1999-2000 and 2004-2006.
Rate hike chart observations:
1. During the initial phases of the rate hike cycle, it is common to see increased S&P 500 market volatility with some sharp, short-duration sell-offs.
2. From the beginning to the end of the previous three rate hike cycles, the stock market traded higher.
3. After the rate hike cycles ending in 2000 and 2006, the stock market entered multi-year bearish periods. After the rate hike cycle ending in 1995, the market accelerated upward for the next five years at its fastest pace in modern history.
At the beginning of last December, the S&P 500 was trading near the 2080 level. This is essentially where the S&P 500 is today.
What got us from there to here was a mix of offsetting forces. Up till now, earnings growth has been distressingly flat, with FactSet reporting a first quarter growth of just 0.1%, the worst performance since 2012’s third period (down 1%). Quarterly earnings growth since has mostly been in the low teens.
On the other hand, low interest rates allowed for price/earnings ratio expansion, with the multiple for the S&P 500 inching past 20. This signals that investors are optimistic about the market. The addition of equal positive and negative forces equated to zero net S&P market change.
Going forward, analysts polled by FactSet expect earnings growth Fed to pick up (a plus, obviously) but interest rates have started to rise placing downward pressure on P/E multiples (minus). Based on rate hike history, expect higher volatility in the coming months and possible sharp, short-duration sell-offs. Don’t be surprised to see stocks rise during the multi-quarter period that the Fed actively raises rates.
Once the rate increases have concluded (the Fed currently expects them to level off about 3.75% on the fed funds rate), the risk of a major bear market is elevated. Buy-and-hold investment solutions today may be as risky as they were in 1999 and 2006, just before multi-year bearish periods. Now, more than at any time since the last Fed rate hike period, it is important to have in place a disciplined plan for reducing equity exposure.
But by the same token, history also shows the end of Fed rate hike periods may also mark the start of a major bull run.
That’s where those other forces come in. In 1995, American was in the midst of the tech boom, and the market continued to soar. In 2000, the tech bust hit, and the market tanked for three years. In 2008, the housing bubble burst and the worst economic downturn since the Great Depression ensued, so stocks really plunged.
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Nicholas Atkeson and Andrew Houghton are the founding partners of Delta Investment Management, a registered investment advisory firm in San Francisco, and authors of the new book, Win by Not Losing: A Disciplined Approach To Building And Protecting Your Wealth In The Stock Market By Managing Your Risk. Additional market commentary and investment advice is available via their websites at www.deltaim.com and www.deltawealthaccelerator.com
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