What Rising Rates Mean for Stocks

If you assume that the Fed has a hike or two to go, then the smart policy is to inspect your portfolio and take some lessons from the past

By Palash R. Ghosh

From Standard & Poor's MarketScope

Rising interest rates rank near the top of investors' worries as the Federal Reserve continues to tighten credit to keep a lid on inflation. How should stock and fund investors respond to higher rates? Should they even fret?

In early November, the Federal Reserve boosted the Fed funds target rate by 25 basis points, to 4.00%, representing the twelfth straight rate hike since June, 2004. As the Fed prepares to install a new chairman, Ben Bernanke, in 2006, the central bank is probably not done raising rates, according to Standard & Poor's Global Investment Policy Committee (IPC).

"We believe there's a chance the Fed will vote to raise rates 50 basis points at the December meeting, and then make no change at the January 31 meeting," IPC said in a statement. "This would signal the end of the rate hikes, in our view, and allow Chairman Bernanke more freedom in setting policy after Jan. 31."


  If the Fed raises rates a quarter point in both December and January, a more likely scenario, in S&P's view, the committee thinks it will be hard for Chairman Bernanke not to raise again at the beginning of his term. As a result, S&P believes the Fed will probably end the current tightening cycle at 5.0%.

What does all this mean for stock pickers? Investors would be wise to remember four important things about rising rates:

• It takes up to one year for a change in rates to work its way into the economy and markets.

• Stock prices anticipate rate changes well ahead of time, and respond accordingly.

• Although rates are currently rising, they still remain at historical lows, and

• Rates are only one component of a vast and complex macroeconomic system.

Indeed, since June 30, 2004, when the Fed initiated its current credit tightening scheme, the S&P 500 gained 8.3% through Nov 1, 2005. Over that period, short-term rates quadrupled to 4.00% from 1.00%. Similarly, the S&P MidCap 400 index rose 17.0%, and the S&P SmallCap 600 index climbed 15.8% over that period.

Rising rates didn't dent equity returns. Though were coming off of a low base in this example, stock markets have still performed well in anticipation of the end of a rate-tightening cycle, according to Sam Stovall, chief investment strategist at Standard & Poor's. Stovall says that since the early 1970s, the S&P 500 advanced an average of 3% in the three-month period preceding the last rate increase of a tightening period.


  By the same token, falling interest rates do not necessarily translate into booming stock prices. For example, between Jan. 3 and Dec. 11, 2001, the Fed cut short-term rates from 6.50% to 1.25%. However, over that period, the S&P 500 declined 12.4%, and the S&P MidCap 400 rose a meager 1.4%. The small-cap Russell 2000 index did, however, record a 3.1% gain. But with the dislocation inflicted by the Sept. 11 terrorist attacks, it was hardly a "normal" year.

While rising rates may not always dramatically hurt the equity markets as a whole, they clearly impact specific sectors.

Traditionally, during periods of tighter credit, investors are advised to move out of "rate-sensitive" industries (banks, financials, utilities, real estate investment trusts, among others) and shift into "safer" defensive segments of the economy (food & beverages, health care), which can prosper regardless of a credit crunch.


  However, Quincy Krosby, chief investment strategist at The Hartford (HIG ), points out that even among sectors that tend to incur losses during periods of climbing rates, investors can still find pockets of outperformance.

For example, among financials, Krosby thinks brokerage companies may continue to do well, because the market "knows M&A activity will continue to be strong." Jerry Jordan, portfolio manager of the Jordan Opportunity Fund (JORDX ) says, "theoretically, when rates rise, you're not supposed to own financials. That adage still holds true, but at some point, the market discounts that."

John Buckingham, manager of the Al Frank Fund (VALUX ), figures that when rates rise, it is time to start investing in stocks, particularly in sectors that will be hurt by the tightening. For example, based on anticipated higher interest rates, financials and homebuilders have "already sold off, and they represent good value," he says.


  "As a result, I want to be buying financials like Citigroup (C ; recent price, $49), Countrywide Financial (CFC ; $36) and H & R Block (HRB ; $25), and homebuilders like D.R. Horton (DHI ; $36)." (Standard & Poor's has investment rankings of 5 STARS [strong buy] on Citigroup, 4 STARS [buy] on Countrywide and D.R. Horton, and 3 STARS [hold] on H & R Block.)

Size may also play a role in stock selection during periods of rising rates. "When interest rates move up, economic growth slows down," says Rosanne Pane, mutual fund strategist at Standard & Poor's. "Investors are attracted to companies with high-quality and consistent growth. We believe this tends to favor the large-cap companies. On the other hand, small-cap stocks, which usually exhibit higher growth rates, tend to perform better when the economy is rebounding, as we saw in 2003."

Historical data show that after a period of credit-tightening ceases, certain key sectors have performed very well over the next 12-month period. For example, on Feb. 1, 1995, the Fed completed a year-long tightening campaign that saw interest rates double, to 6.00% from 3.00%. For the one-year period ending Feb. 1, 1996, the average sector fund in five key sectors -- financials, health care, real estate, technology, and utilities -- delivered powerful gains.


  Jordan says he is concerned by today's higher rate environment. He recently moved 15% to 20% of his fund's assets into cash. Looking ahead, he is moving into areas that he believes will do better in a declining market and slower economic environment, including big pharma, generic drugs, hospitals, biotech, and some consumer areas.

"Historically, as rates rise, commodity-oriented, cyclical, and industrial sectors have done better than the overall market because rising rates confirm that the underlying economy is strong and that business continues to be good," notes Jordan. But at some point, he added, "the market discounts an eventual economic slowdown, and rotates into companies that can continue to grow earnings during an economic deceleration."

Ghosh is a reporter for Standard & Poor's Global Editorial Operations

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