(10/08/14) Rising Rates: A Historical Look

Many investors fear that a reversal of the Fed's easy monetary policies since 2009 may lead to a significant reverse in the stock market's advance, or even a big bear market, notes Mark Salzinger, editor of The Investor's ETF Report.

Though we agree that the Fed will begin a rate-rising cycle in 2015, we disagree that this alone will necessarily stop the bull in its tracks.

One way to keep things in perspective is to look at history for clues about the future. What has happened to equities in the past when the Fed raised the interest rates under its control?

Since 1955, the Federal Funds Rate has been higher 30 times at the end of the year than at the beginning. During these years of higher short-term rates, the average annual return of the S&P 500 (SPX) was 7.8%.

Meanwhile, the average annual return of small-cap stocks (mainly the value variety as opposed to growth) was 11.7%.

In other words, while the large-cap S&P 500 index lagged its overall annual average of 10% or 11%, it still averaged out to pretty decent money, while small-caps performed quite well. In 21 of the 30 years, the S&P 500 and small-caps both made money. Those are decent odds.

The worst rising-rate period was 1973-1974, when stocks lost 40% to 50%. This coincided not just with higher short-term rates, but also general economic upheaval and nearly four-fold rise in crude oil.

During the 28 years in which the Federal Funds Rate fell, stocks have generally performed better.

In fact, the S&P 500 produced an average annual gain during those periods of 15.3%, while small-caps did even better, an average annual return of more than 20%. The S&P 500 rose in 24 of the 28 years, while small-caps rose in 20.

However, it's worth noting that the worst year for the market, 2008, coincided with a decrease in the Federal Funds Rate of more than three percentage points, and that the S&P 500 produced significant losses in the aftermath of the tech stock mania, when rates also fell (2001-2002).

We can draw several conclusions from this financial history.

First, stocks tend to perform better when short-term rates are falling than when they are rising.

Second, notwithstanding our first conclusion, stocks can certainly produce gains even during periods of rising rates, and have done so more often than not.

Third, rising or falling rates by themselves do not determine the path of stocks. It's clear that other factors, including the broad economy, supply shocks, and equity valuations are at least as important.

In fact, it's a worthwhile exercise to view changes in short-term rates as symptoms of what may impact the markets rather than as causes. In other words, if rates are falling because of a deep recession or credit crisis, stocks are likely to fall anyway.

Conversely, if they are rising because the economy is growing, the increased profits from the latter are likely to outweigh any negative impacts caused by higher rates.

Such appears to be the most likely outcome for the next 12 months, which is one reason we continue to believe stock prices are likely to be higher a year from now than they are today.