One of the oldest rules on Wall Street is, don't fight the Fed. When the Federal Reserve is cutting rates, you want to be long equities, and when it is tightening, get out of the way. This has been a cause for concern since the Fed began talking of tapering its program of quantitative easing and ending its zero interest-rate policy.
But the knee-jerk response to an over-simplified rule of thumb might be wrong. When we look at the actual data -- what happens to stocks when rates rise -- we find a very different set of results than this heuristic suggests. Before I get to the numbers let's look at both the positive and negative sides of increasing rates.
It is understandable that there is concern with a rising-rate environment. Often, higher rates signal an overheating economy, higher costs of credit to purchase goods and services and a potential profit squeeze as operating expenses rise. When the Fed is in its inflation-fighting mode, too much tightening will cause a recession.
However, there are also positives to increasing interest rates. Rates are merely the price of capital. Higher demand for capital means the economy is strengthening, as consumers borrow to spend on goods and to buy homes and companies seek to hire and do more investment spending. Higher rates also mean the risk of deflation is decreasing. Lastly, it reflects a normalization of Fed interventions, which today would suggest that the credit crisis is behind us.
Each of the positive and negative scenarios has occurred in different economic cycles and they each contain specific combinations of variables. When all of these inputs interact, we end up with a broad range of possible outcomes.
Unfortunately, there is no rule of thumb that will give us a simple investment formula. What the data show is something more nuanced and complex than you might assume.
Consider the impact of rate movements on the Standard & Poor's 500 Index during the past century or so. On 86 occasions interest rates changed significantly during the course of a calendar year. The effects of these changes produced a diverse array of market outcomes, thanks to the interaction of a variety of factors.
When we analyze the data, we find that almost three-fourth of the time when rates were rising stocks tended to rise as well. When we looked at the conditions during these periods of rising stocks and rates, we found that the 10-year bond yield averaged 5.11 percent, the price-earnings ratio of the S&P 500 averaged about 15, and inflation as measured by the consumer price index was more than 4 percent. The average S&P 500 increase during these periods was almost 21 percent.
In the instances when rates rose and stocks fell, the S&P 500 declined almost 16 percent on average. At the same time, the 10-year bond yield averaged more than 6 percent, the P/E ratio for stocks was a historically low 12.57 and inflation was high, averaging 6.8 percent. This combination of high rates, rapid inflation and cheap (and getting cheaper) stocks typically implies a recessionary environment.
Back to our opening premise of "Don't fight the Fed,'' a phrase coined by market strategist Martin Zweig. He made that statement during the stagflation of the 1970s, and it provided a rationale for avoiding stocks when the central bank was raising rates. His advice was sage then, but it applied in an era of high interest rates and daunting inflation. We don't see those conditions today.
My takeaway: When inflation is high, and rates are going up from elevated levels, we see a negative impact on stocks. When inflation is subdued, and rates start increasing from low levels, the impact on stocks is positive.
This latter case is most similar to the environment we find ourselves in today, so I'm skeptical of the popular idea that increased interest rates will be a minus for the S&P 500. Although we may be overdue for a market correction, that need not mark the end of the bull cycle.
If history holds true, rising rates this year or next shouldn't hurt either the economy or the equity markets.
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