By Sam Stovall It seems March went out like a lion, at least where economic data were concerned. The employment, retail-sales, and consumer-price-index reports for the month, released during the first two weeks of April, each had one thing in common: Each was much stronger than expected.
As a result, investors began fretting over when the Federal Reserve will raise interest rates, and also to wonder which sectors and industries may be most vulnerable to attempted profit-taking. If the Fed decides to raise short-term interest rates soon -- and if history repeats itself -- the consumer-discretionary, financial, and industrials sectors will likely be hit the hardest.
Since 1970, there have been six periods in which the Fed has orchestrated a series of interest-rate increases. (In 1984 and 1997 they raised rates, but only once time each.) The tightenings began on:
June 30, 1999
February 4, 1994
September 4, 1987
September 25, 1980
August 29, 1977, and
January 12, 1973.
Six months after the first hike in the series, the S&P 500 fell an average of 5% (as seen in the table below, it declined in four of the six periods and rose in 1999 and 1980).
First Rate Hike
Total no. of hikes in tightening cycle
S&P 500 % chg. 6 mos. after first hike
More surprising, however, was that while the overall market declined only modestly during the six months following the first rate hike, all but one of the 56 industries present in all six observations fell during the same period.
The list of those industries with the best six-month average performances after a rate hike contains a few surprises. Even though industries in consumer staples and health care usually come to mind as typical defensive plays, the tech sector didn't suffer as badly as many would have expected.
In addition to the strong showing by Electronic Instrument stocks (see table below), the Computer Hardware and Semiconductor industries, which just missed the cut of the top five performers, each posted average declines that were less than that for the overall market. Why? In our view, it may owe to the need for companies to continue to improve productivity in order to remain competitive.
The roster of those industries with the worst showings contains no shocks, in our opinion. We regard each as a textbook example of groups most directly exposed to rising rates.
Best- and Worst-Performing Industries After a Rate Hike
% Chg. 6 mos. after hike
Iron & Steel
Health Care (Medical Products & Supplies)
Containers (Metal & Glass)
Household Furnishings & Appliances
Trucks & Parts
Savings & Loans
The table below highlights average sector performances (based on the average performances of underlying industries in the S&P 500 that were in existence as of December 31, 2001), showing the average price performances six months before the initial rate hike, as well as six and 12 months after the initial rate increase. While history should always be viewed as guide and not gospel, investors may use this information as a gauge of which areas may be hit hardest if and when the Fed ultimately raises rates.
% Changes Before and After Initial Rate Hikes from 1970-2000
6 mos. before hike
6 mos. after hike
12 mos. after hike
As a result of the strong employment, retail-sales, and CPI reports for March, we now believe the odds favor a Fed funds-rate increase of 25 basis points at the upcoming June FOMC meeting. David Wyss, S&P's chief economist, currently sees the yield on the 10-year Treasury note rising to 4.75% by the end of 2004, and 5.50% by year-end 2005. He projects the Fed funds rate to approach 1.75% by the end of 2004, from its 1.00% level currently, and climb toward 3.50% by the end of next year.
This revised outlook has caused S&P's Investment Policy and Sector Committees to recommend adjustments to expected gains for the S&P 500 in 2004 and for suggested sector weightings. Specifically, the IPC voted to reduce its yearend 2004 target for the S&P 500 to 1,215, from 1,230, implying a 9% gain for the S&P 500 this year.
In addition, we recently recommended that investors underweight their exposure to the financials sector (See BW Online, 4/16/04, "Less Weight for Financial Services"). Even though we remain positive on a number of consumer-finance, asset-management, investment-banking, and property-casualty insurance companies, we cannot overlook the fact that most of the financial-services sector historically has underperformed the S&P 500 in a rising-rate environment. Moreover, we believe valuations of some subsectors do not adequately reflect our interest-rate concerns.
WHERE THE BUYS ARE. Despite our heightened awareness of a pending direction change in interest rates, we still believe equities offer better return prospects than bonds or cash, due to our continued strong outlook for earnings. What's more, a greater proportion of S&P analysts' buy recommendations continue to be found in the consumer-discretionary, nonpharmaceutical health-care, and information-technology sectors, due to full-year earnings expectations and current valuations.
S&P analysts forecast a 19% increase in operating earnings for the S&P 500 for the first quarter of 2004 and a full-year rise of 16%, led by full-year increases of 58%, 55%, 25%, and 22% for the technology, materials, health-care, and consumer-discretionary sectors, respectively. In addition, earnings for the S&P MidCap 400 and SmallCap 600 indices are projected to advance more rapidly than that for the S&P 500.
All told, while we believe that higher interest rates could cause share prices to advance more slowly than estimated earlier, we still see the U.S. equity markets posting healthy advances during the remainder of the year.
Industry Momentum List Update
For regular readers of the Sector Watch column, here's this week's list of the 11 industries in the S&P Super 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500) as of April 16, 2004.
S&P STARS* Rank
Casinos & Gaming/Consumer Discretionary
Catalog Retail/Consumer Discretionary
Insight Enterprises (NSIT)
Consumer Electronics/Consumer Discretionary
Harman International (HAR)
Diversified Metals & Mining/Materials
Phelps Dodge (PD)
Electronic Equipment Mfrs./Info. Tech.
Fertilizers & Ag. Chemicals/Materials
Scott's Co. (SMG)
D.R. Horton (DHI)
Internet Software & Services/Info. Tech.
Wireless Telecom Svcs./Telecom Svcs.
Nextel Communications (NXTL)
S&P's stock appreciation ranking system for the coming 6- to 12-month period: 5 STARS (buy), 4 STARS (accumulate), 3 STARS (hold), 2 STARS (avoid), 1 STAR (sell). Stovall is chief investment strategist for Standard & Poor's