There is a lot of lip service being paid to the stock market crash that we’re supposed to expect once the Federal Reserve starts raising rates.
Every time we get close to a regularly scheduled Federal Reserve statement, financial pundits pontificate about the nuances of what the Fed chair might say, not say, or imply.
It’s like clockwork.
But one theme remains constant: Any tightening of the Fed’s easy monetary policies will spell impending doom for the easy-money-addicted stock market.
The only problem, though, is that historical facts just don’t support the fear. In fact, there are opportunities for investment out there no matter what rates do…
First, let’s rewind a moment to late 2013.
Just about every talking head in the financial media was sure that stocks were going to crater as soon as the Fed announced even a whiff of a taper in its bond-buying program.
And then the Fed began…
On December 18, 2013, it announced it would start to taper its aggressive bond-buying program to $75 billion a month beginning in January 2014 – and what happened?
The S&P 500 rallied to a then-record close of 1,810.65.
Oops, I guess traders forgot to listen to the talking heads.
And there was a good reason for that.
Traders are constantly taking in all available information and continually adjusting positions accordingly. So when the Fed announced initial plans to taper, the news had likely been priced into stocks for weeks – if not months.
And the fact that the taper was just $10 billion a month was a pleasant surprise.
Fast-forward to September 2014. The Fed closed its QE3-related bond-buying program – and the markets had gained 9.5% from the initial December 18, 2013, announcement.
Traders who swallowed the taper-tantrum red pill and moved to cash in December 2013 had a lot of catching up to do – and that means they are likely going to have to take on excessive risk to make up the difference.
But as soon as the Fed ended QE, the dialogue shifted to “rising interest rates.” The almost unanimous opinion is there will be a sell-off because the market, the economy, you name it, are all addicted to cheap credit.
I don’t buy it – and I have the hard facts to support my position.
The chart below demonstrates S&P 500 performance vs. the fed funds rate going all the way back to December 1, 1971.
It might be hard to see what’s truly happening in that chart, so I broke it down in the table below, based on seven sample periods when the Fed was raising the fed funds rate.
Six out of the last seven periods during which the Fed was raising rates, the markets actually went up – gaining an average 13.47% during the rising-rate periods.
And, as you can see below, the only time the S&P 500 didn’tincrease in value alongside rising rates was all the way back in the early 1970s, when the fed funds rate increased a whopping 9.21 percentage points, from 3.71% to 12.92%.
I don’t know about you, but I’m not too concerned with the Fed raising rates to nearly 10% anytime soon.
What’s lost in all the chatter about the Fed increasing rates is one simple point: The Fed typically only raises rates when it believes the economy can absorb the increase – and even then, it’s usually slow to finally increase rates.
When it does, the increases come in small increments that the market can digest… at least to a point, then the cycle reverses, the economy goes into a recession, and the Fed lowers rates again.
I don’t see any reason to think Team Yellen is going to break with tradition and raise rates so fast as to kick the feet out from under the U.S. economy.
Granted, once the Fed does increase rates you can expect a period of volatility – but don’t read too much into it.
Of course there’s going to be volatility as institutional traders around the world adjust their respective positions based on risk models that use the fed funds rate as a critical input.
And then there is the correlation of 10-year U.S. Treasurys to the fed funds rate…
The chart below demonstrates an 89.94% correlation between fed funds rates and U.S. 10-Year Treasury rates.
Of the data so far, the chart above might be the most important because of how it correlates to the first rule of money: Capital always goes where it’s treated best.
If 10-year rates are “increasing” it’s because traders are “selling” – and that freed-up capital has to go somewhere. I think it would follow historical examples and move into equities.
Could you make the argument that “This time it’s different,” because the Fed has injected so much liquidity into financial markets? Sure you could. But it would represent a break with historical norms and I’m more interested in historical statistics than unproven hypotheses.
Could you make the “All that liquidity is going to eventually create massive inflation” argument? Sure you could. But inflationary periods have typically favored stocks, so that would likely favor equities.
Finally, could you make the “Geopolitical risk will drive a flight to safety into U.S. debt and out of equities” argument? Yes, of course, you could. But that condition would likely be temporary. Eventually the 89.94% correlation between 10-year Treasurys and the fed funds rate would normalize and 10-year rates would likely rise, which favors equities.
So when the Fed does raise rates – and the inevitable short-term rate riot occurs – we’ll use the volatility to go shopping.
In fact, I’ve already put readers on alert for this possibility in my trading service, Small-Cap Rocket Alert.
If that sounds risky, I understand. But consider one of my favorite Warren Buffet quotes: “Be fearful when others are greedy and greedy when others are fearful.”
No doubt, it takes a lot of courage to buy when the market is selling – but doing so is the best way to lower your risk and juice your returns.
Case in point: I told my subscribers to use the October 2014 sell-off (when the S&P 500 dropped 7.38% in less than a month) as a buying opportunity and recommended a $450 million network visibility company. It’s up 55%, compared to a 5.31% gain in the S&P 500 over the same time period.
If you want to make the same move and have similar potential, consider establishing a position in iShares Russell 2000 Index (ETF) (NYSE: IWM) or iShares Micro-Cap (NYSE: IWC).
And don’t forget to thank Janet Yellen for giving you the opportunity.
You can smile all the way to the bank later.
Chief Research Analyst, Money Morning
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