What a Week: Third Rate Hike Is Not a Charm

Three hikes by the Federal Reserve, and the market tumbles.

Coincidence? Probably, but the confluence of events generated discussion about the old adage "three steps and a stumble," which refers to the notion that a third-successive rate hike is not charming for stocks.

On Tuesday, the Fed tightened for the third time this summer, and major averages closed lower for the week: The Dow lost 2.3% while the S&P 500 fell 1.6% and the Nasdaq Composite lost 1.5%.

The phrase was coined by legendary market technician Edson Gould (reigning guru of the 1970s) and reflects the idea that "the Fed typically raises interest rates only when the economy is 'hot' and needs to cool off," observed Raymond James strategist Jeffrey Saut.

"Since it tends to take months for a rate-ratchet to work its way through the economy, Edson deduced that three interest rate increases was the magic number needed to override the effects of a strong economy," Saut said.

(The yield on the 10-year Treasury seemed to support that notion this week, falling to as low as 3.96% intraday Thursday before settling at 4.03% Friday.)

Arguably, it might take at least three rate hikes for some traders to believe the Fed really is going to take away the proverbial punch bowl, and history has shown Gould's rule is worth heeding. Since the Fed was founded in 1914, Gould's warning has been triggered 15 times and every time the market suffered a decline thereafter, usually within 12 months, Saut noted.

But some believe the "three steps and a stumble rule" has less bite today. The following chart, courtesy of David Merkel, senior investment analyst at Hovde Capital and a RealMoney.com contributor, suggests that "three steps" haven't caused much of a stumble in the past 30 years -- save for the six months immediately following the third hike, and even then, by modest amounts.

Three Steps and ... a Mixed Result: Since 1973, three rate hikes have, on average, hurt stocks only six months later
Date	S&P*	One-Month	Three-Month	Six-Month	One-Year
1/12/1973	119.3	-3.87%	-6.05%	-12.75%	-21.49%
4/24/1974	90.3	-1.90%	-5.88%	-21.34%	-4.72%
9/15/1977	96.8	-3.35%	-3.36%	-7.53%	7.56%
9/25/1980	128.72	0.88%	5.56%	5.87%	-12.39%
6/22/1984	154.46	-3.18%	7.26%	7.15%	22.76%
5/20/1987	278.21	10.34%	18.55%	-11.74%	-9.22%
5/25/1988	253.76	7.89%	2.90%	6.01%	25.78%
4/18/1994	442.46	2.54%	2.88%	5.99%	14.22%
11/16/1999	1420.03	-0.09%	-1.27%	3.24%	-2.13%
9/21/2004	1129.3	TBD	TBD	TBD	TBD
Average		1.03%	2.29%	-2.26%	2.79%
* Price on day of third rate hike. Source: Hovde Capital