Yesterday the Federal Reserve hiked the federal funds rate .25% (25 basis points) to .75%-1.0%. The hike was in line with market expectations. The market reaction was a rally to 2385 by the close (March 15). Meanwhile the dollar fell. US stocks are up roughly 6.4% since the beginning of 2017 and over 11% since the November election.
Why Did the Market Rally?
The market was expecting this rate hike so why did the market rally so strongly? In recent weeks there has been a good deal of talk about the potential for the Fed increasing the number of rate hikes going forward. The Fed ‘dot plot’ is a chart which captures the members’ views on rate levels and rate hikes. The dot plot released shows that the median number of interest rate increases remaining for 2017 is two, this is in line with the prior ‘dot plot’. Also, there had been some concern that the Fed may signal long term rates above 3%, but those were also unchanged. The concern over a more hawkish fed waned and the market pressed higher. We can also see the impact as the dollar rose against other major currencies.
What is the Relationship Between Interest Rates and Stock Prices?
I was disappointed to read several articles suggesting that the stock market is not impacted by higher rates. This may be true over short periods of time, but over longer periods of course the stock market responds to interest rates. One way to think about this is to consider that asset classes are ‘competing’ for your dollars. If bond rates go up, then all things being equal, you are more likely to hold bonds vs. stocks and expect higher return from your stocks (causing prices to come down).
The problem is that there is no clear cut formula for making the call as to when interest rate increases will impact the stocks. To make matters worse, market corrections come quickly. The long term data suggests that rates below 3% are less likely to generate declines. Another Wall Street adage, popularized by Marty Zweig, is ‘Three Steps and a Stumble’. This implies that the market tends to correct after the third fed funds rate hike.
In May of 2013 I wrote an article entitled, ‘Will a Fed Rate Hike Hurt Your Equity Portfolio?’. I noted that in the first year of trading following the initial rate hike that the median market return was 9.7%. Three of 12 cases resulted in down markets. It is interesting to note that the first actual rate hike didn’t occur until December of 2015. The year following the first hike, the market was up 11.96% in 2016.
This highlights the difficulty in trying to make timing calls on the market based on looking solely at interest rates. Stock market valuation, GDP growth and productivity are significant factors as well.
How Do Market Valuations Look?
With the recent market gains, the forward PE for the S&P 500 is roughly 18. From a historical basis, this is above the 90th percentile. However, rates are at long term lows. Using a discounted earnings model, expected return of 6.75% and a real earnings growth rate of 1% the justified PE would be 17. The market is somewhat overvalued.
Again, the calculations assume continued low rates and sustained growth. Let’s say 10Y treasury rates jump from 2.6% to 4%. Now we require higher returns from stocks if bond interest rates go up. If required return goes to 7.75% and we hold real growth in earnings at 1%, the justified PE would become 15.38. Using this scenario, the market would be 20% over-valued.
What to Watch
Given the brief discussion on valuation, we are keenly focused on 10Y treasury rates and GDP growth. As previously noted in this article, Jeff Gundlach has forecasted that rates would rise to 3% by year end. He reiterated this forecast yesterday on CNBC. Since the election, ten year rates have moved between 2.4% and 2.6%, and as of today stand at 2.53%. If treasury rates breakout above 2.6% and head toward 3% our level of concern goes up. I am personally a bit skeptical that we can hit 3% this year unless we see stronger wage growth, inflation over 2% and real GDP above 1%.
As far as GDP growth, the Atlanta GDP Now forecast figure for March 16th is a meager .9% annual rate. Consumer confidence remains high, but retail numbers have been weak. The February jobs growth came in at 235,000 new jobs – the best growth in 10 years. However, if this jobs growth and consumer confidence doesn’t translate into higher growth the market will react. For her part, Janet Yellen was asked about the latest GDP number. She brushed it off as ‘just a single data point’.
Confused? Don’t be. The data we are getting right now is mixed at best.
We are staying the course with our model portfolios. Namely, well diversified stock-bond allocations with a bias toward quality, low-risk and US based equities.