RATE HIKES CAN BE GOOD
WHY YOU SHOULDN’T BE SO WORRIED. MARK HULBERT,
Investors may be overly concerned about the Federal Reserve raising interest rates.
Last week Fed Chair Janet Yellen said that the case is getting stronger for a rate hike later this year — possibly as early as the Fed’s September meeting, scheduled for Sept. 20 and 21. Stanley Fischer, the Fed’s vice chairman, went further and said that he foresaw the possibility of two rate hikes in the remaining four months of 2016.
If the market does sell-off in the wake of a rate hike, you might want to resist the urge to liquidate your stocks — and even consider treating the sell-off as a longer-term buying opportunity.
Take what happened in the wake of last December’s rate hike, the Fed’s first in nearly a decade. After falling by more than 2,000 points over the subsequent two months, the Dow Jones industrial average came roaring back. Today it’s trading for 18% more than it was at its February low and 4% higher than on the day of the Fed’s rate hike.
Past Fed rate hikes haven’t always been followed so quickly by such happy outcomes. It sometimes has taken several years for the market to recover from its initial shock. But, on average over the last 140 years, the stock market’s longer-term returns have been higher in the wake of higher interest rates rather than lower.
That’s just the opposite of what most investors fear, of course.
Why might higher interest rates not be as bad as many investors fear? One answer comes from the Fed itself: It will raise rates only when the economy is strong enough to withstand them. From that perspective it can seem odd that investors would hope rates stay low indefinitely.
This doesn’t mean that higher rates, in and of themselves, are good for the stock market. But it does mean that the relationship between interest rates and the stock market is anything but simple.
Cliff Asness, founding principal at AQR Capital Management, a money management firm with $159 billion under management, several years ago set out to discover whether one could improve one- and 10-year stock market forecasts by taking interest rates into account. He compared two forecasting models: One relied solely on the simple price-toearnings ratio, perhaps the most widely-used measure of stock market valuation; the second incorporated both the P/E ratio and interest rates.
He found that, since the late 1800s, the second model had no better track record than the first. In other words, taking interest rates into account did nothing to improve forecasting accuracy.
Because the stock market’s current P/E ratio is well above historical averages, Asness’ finding suggests that we might want to be more worried about it than a possible Fed rate hike in coming months. Based on trailing 12month earnings, for example, the S&P 500’s P/E today is 25-to-1. That’s 60% higher than the average of comparable readings over the last 140 years.
To be sure, P/E ratios in recent decades have been higher than they were a century ago, so this longer-term comparison might be unfair. But the current level is still 32% higher than the average of the last 50 years.
In fact, the market’s current P/E is higher than it was at 32 of the 36 bull market tops since 1900.
If you choose to heed the P/E ratio’s warning, you should be reducing your portfolio risk now rather than waiting until the Fed raises rates — when you could find yourself trying to sell alongside myriad other panicked investors who want to sell at any price.
On average, the stock market’s longer-term returns have been higher in the wake of higher interest rates rather than lower — just the opposite of what most investors fear.