The EFFECTS OF RISING RATES ON STOCKS

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Tracking the effect of rates - Kathleen PenderSunday, April 25, 2004
Alan Greenspan clearly has his finger on the interest-rate trigger. The question for stockholders is whether he's holding a pop gun or an AK-47.
Historical studies show that after a period of falling or stable interest rates, one or two interest rate increases did not, on average, hurt the stock market. But a sustained series of interest rate hikes usually did.
Here's why: The Fed typically raises rates when an economic recovery has taken hold and inflation starts looking like a problem.
A single rate increase, sometimes even two, doesn't usually slow the economy or put much of a dent in corporate profits, so investors remain bullish on stocks.
And in the early days of rising rates, stocks don't get much competition from bonds and other fixed-income investments.
When interest rates go up, bond prices go down, and investors are reluctant to jump into bonds while their prices are falling, even if their yields are going up.
But after three or four interest rate increases, the economy and corporate profits will start to slow. And at some point, many investors will switch out of stocks into bonds, when they decide bond yields are high enough to compensate for any risk of further price declines.
The Leuthold Group has studied the stock market's performance following Fed rate increases going back to 1946.
"A year after the first increase, you see the market up about 10 percent over that time frame. As you get into third and fourth rate increase, that's where it really has a bite," says Andrew Engel, a senior research analyst with Leuthold.
His study shows that a year after the sixth in a series of rate hikes, the Standard & Poor's 500 index was down almost 7 percent.
When multiple rate increases do kick in, few sectors of the market are spared.
Standard & Poor's studied the market's performance following Fed rate increases for the period since 1970. (It excluded periods when the rate was raised only once before it was cut again.)
It found that the S&P 500 was down, on average, about 5 percent six months after the first in a series of rate increases.
"More interesting, of the 56 industries in the index (that were around for the entire period), only one was higher" six months after the initial rate increase, says Sam Stovall, S&P's chief investment strategist. That one was electronic instruments.
Laid-back approach: There are reasons to believe the Fed could take a leisurely approach to raising rates.
Although the consumer price index jumped a surprising 0.5 percent in March -- following gains of 0.3 and 0.5 percent in February and January -- inflation is tame by historical standards.
And the federal funds rate, stuck at 1 percent since last June, is extraordinarily low.
The difference between the federal funds rate, at 1 percent, and gross domestic product, which is growing at a 6 percent rate, "is artificially very wide. If they raise the federal funds rate, they are taking their foot off the gas, not putting it on the brake," says Stovall.
This suggests the Fed could raise the rate, sit back and see what happens, without roiling the stock market.
"An increase in rates from really low levels won't worry people as much as if they come up from a high level," says Sam Burns, senior equity analyst with Ned Davis Research.
What's different this time, and worrisome, is that "there is a lot of debt in the economy. The ratio of debt to GDP is the highest it has ever been, " Burns adds.
"Rising rates may have more impact now," he says. Because households are over-extended, a small rate increase could cause a bigger-than-usual slowdown in housing, autos and other key parts of the economy. That could prevent further rate increases, but it would also be bad for corporate earnings and stock prices.
The other fear is that inflation could shoot up higher and faster than anticipated, forcing the Fed into rapid-fire rate increases.
Here's what Greenspan told Congress about inflation and interest rates on Wednesday:
"As I have noted previously, the federal funds rate must rise at some point to prevent pressures on price inflation from eventually emerging.
"As yet, the protracted period of monetary accommodation (in other words, low interest rates) has not fostered an environment in which broad-based inflation pressures appear to be building. But the Federal Reserve recognizes that sustained prosperity requires the maintenance of price stability and will act, as necessary, to ensure that outcome."
Market outlook: The prospect of higher rates has led some analysts to trim their market forecasts.
"We recently reduced our year-end target for the S&P 500, from 1,230 to 1,215. Instead of a low double-digit gain (for the year), we think it will do 9 percent," says Stovall.
After rising 26 percent in 2003, the S&P 500 is up about 2.5 percent this year. It closed Friday at 1,140.60.
In recent weeks, the market has been on a seesaw, rising one day on good earnings and falling the next on concerns about interest rates.
Stephen Sanborn, executive research director with Value Line, says that, on balance, corporate profits will be the decisive influence.
"Our view is that the economy is going to be good at least through 2004," he says. "Corporate profits will boost stock prices more than interest rates will pull them down."
That could change, however, if inflation or long-term interest rates get out of control.
Long-term rates are established by bond investors, and they often move in advance of short-term rates set by the Fed. The yield on the bellwether 10- year Treasury bond has risen sharply, from 3.68 percent in mid-March to 4.45 percent on Friday.
"If you saw the 10- year Treasury bond yield go up to 5.5 or 6 percent, then you might have problems," Sanborn says.
Sector plays: If you own a wide variety of stocks and the desired allocation of stocks, bonds and cash (i.e. money market funds) based on your age, financial goals and risk tolerance, there is probably no need to make major changes.
But if you are overweighted in stocks that could get hurt by rising interest rates or underweighted in sectors that could do well, you may consider some adjustments.
The sectors most vulnerable to rising interest rates are financial services (such banks, thrifts and brokerage firms) and anything real estate- related, including homebuilders, building materials and real estate investment trusts.
Utilities, which are purchased mainly for their dividends, can get hurt later in the interest-rate cycle as income-oriented investors switch into bonds.
Most of these industries have already been hurt by rate jitters.
In the past month, the REITs in the S&P 500 are down 12 percent, homebuilders in the index have fallen 9 percent, thrifts are down 5.5 percent, investment banks/brokerage firms are down 4 percent, and electric utilities have slipped 2 percent.
During the same period, the entire S&P 500 has risen 4.3 percent.
Engel, of the Leuthold Group, says his firm is positive on the market overall, but "we are trying to avoid the financial area."
David Darst, chief investment strategist for Morgan Stanley's individual investor group, says REITs, homebuilders and "certain banks and thrifts are areas we would underweight. We think they can fall further. We would not chase them."
Sanborn on the other hand, says, "I think some of the banking and S&L stocks that have come down are fairly attractive at this point," although he is cautious about them for next year.
The sectors that tend to do best when interest rates rise are technology, health care and energy.
Health care holds up because people still get sick.
Technology holds up because most tech companies have little debt, so they are not hurt by rising interest costs. And because they usually don't pay dividends, they don't see shareholders fleeing for higher-yielding investments.
Energy does well because when interest rates go up, inflation is usually rising and so are energy prices.
Engel says his firm is overweighted in health care and energy and is holding utility stocks as a bond alternative until long-term interest rates stabilize.
Darst says investors who are worried about higher rates might hold a basket of energy stocks including the majors, the secondaries (exploration and production companies), natural gas companies and oil drilling stocks.
Market performance after Fed rate increases
This chart shows the median performance of the S&P 500 for a given number of trading days after successive Fed rate increases since 1946.
Net Worth runs Tuesdays, Thursdays and Sundays. E-mail Kathleen Pender at kpender@sfchronicle.com.
Rate increase
252 days later after Sixth -6.98