Markets

Michael P. Regan is a Bloomberg Gadfly columnist covering equities and financial services. He has covered stocks for Bloomberg News as a columnist and editor since 2007. He previously worked for the Associated Press.

No matter what asset class you call home, you've probably already seen enough charts depicting what happens when the Federal Reserve begins to raise interest rates.

You've probably also heard enough about how you shouldn't put too much faith in those charts because this cycle is so much different from all those that came before it.

Yet for whatever reason, it's soothing to study the past when trying to wrap your mind around an unpredictable event, whether it be what financial markets do after interest rate increases or what a football team does on their home field in the rain with a backup quarterback (after an interest rate increase, of course).

Some studies of the past are more believable as predictive statistics than others. Bloomberg's Lu Wang presented a few in an article about the U.S. stock market that stand a good chance of proving to be accurate.

First, the S&P 500 became more volatile in 10 out of the last 12 tightening cycles. Going back 70 years, daily swings in the index increased by 23 percent on average in the six months after the first rate increase compared with the half year leading up to it, according to her reporting. Second, the S&P 500’s price-earnings ratios shrank during the first year in 10 out of the 12 Fed tightening cycles, falling an average 15 percent.

Interestingly, these two phenomenons seem to have begun even before the first rate increase. Daily moves up or down in the index have averaged almost 23 points, more than a third bigger than 2014. The S&P 500 last set a record in May and valuations definitely appear to have stopped their march higher this year:

Valuation Frustration
Expansion in the price-to-earnings ratios for the S&P 500 has stalled this year.
Source: Bloomberg Data
Note: Based on earnings and estimates before extraordinary items.

 

But even if the market got a head start on this rate increase, it's easy to see these trends continuing into next year. For one thing, most Fed meetings will be viewed as potentially "live" meetings when another increase could be made. The Fed's "dot plot" graph shows that probably half of the eight scheduled meetings will produce an increase of 25 basis points. So that means every speech by every important policy maker will have the potential to cause jitters. And with rising interest rates comes more competition for stocks from fixed income plus higher borrowing costs for companies and investors, so it's hard to imagine the valuation expansion resuming anytime soon.  

So what does that portend for the bull market in equities,  which is set to celebrate its seventh birthday in March and go in the books as the second-longest bull market on record in April? More gains are possible, but it will require a pickup in earnings growth. Based on current estimates from analysts, the S&P should experience profit growth of 7.1 percent in 2016. The problem? At this time last year, the forecasts predicted growth of 6.9 percent for 2015, and now it's looking as if the market will be lucky if it doesn't post a decrease in earnings for the year. 

And the sectors with the best earnings prospects for next year aren't cheap, with forward P/Es all higher than forecast profit growth: 

Best Prospects for Earnings Growth
Consumer, health, commodity and financial companies are forecast to have the best EPS growth in 2016.
Source: Bloomberg Data
Based on consensus analyst estimates as of 12/11/2015.

Equities extended gains after the Fed raised rates on Wednesday, but too much shouldn't be read into that even if the rally continues through the end of the month. December can be a funky time when fundamentals sometime take a back seat.

The end-of-year cheer could mean the S&P 500 may get back to its last closing record of 2,130.82 or even higher in the near term, but it's hard to imagine it staying there for too long unless the earnings picture improves considerably. The bull may not be dead, but it's never looked so worn out. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Michael P. Regan in New York at mregan12@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net