Don't Fight the Fed -- Ignore It

"Don't fight the

Fed

" has become a Wall Street mantra over the past few years, but new research shows it isn't a helpful one, at least in predicting short-term trends.

Conventional wisdom holds that when the central bank is raising rates, stocks fall because it becomes harder for companies to borrow money, thus crimping investment and corporate earnings. In addition, rising interest rates can send bond yields higher, which provides further competition for stocks.

Conversely, a drop in rates augurs well for equities because borrowing costs, which can be a major expense, decline and profits rise.

Still, this theory hasn't worked out for investors over the past two years, as the

S&P 500

plunged more than 20% despite the Fed slashing interest rates to 1.75% in December 2001 from 6.50% in May 2000.

Price Pressures

The reason stocks performed so badly during this period was that investors were focusing on the dour state of the economy rather than the liquidity being pumped into the financial system. But now that GDP has started to grow again, investors are less focused on the economy's return to health and more concerned about a potential rate hike.

The fed funds futures contract is currently pricing in a funds rate of 2.75% by year-end, a full percentage point higher than where it stands right now.

"The fear of interest rate hikes is part of the reason that investors are sitting on the sidelines since there is a common perception that as rates increase, markets dip," said Salomon Smith Barney analyst Tobias Levkovich.

Still, he believes this perception is misleading. According to a study he conducted, stocks climbed in 58 of the last 87 years even though interest rates (as measured by the discount rate) declined in only 31 of them. "This tells you that stocks can perform when rates go up," he said.

Equity indices rose in 22 of the years when interest rates fell, or 70% of the time, while stocks appreciated in 36 years when rates rose, or 64% of the time. "In this context, it is almost a dead heat if stocks climb when interest rates increase or decrease," Levkovich said.

Lidster

A classic example of the ineffectiveness of Fed tightening on the markets can be seen in 1994. The central bank boosted rates six times that year, and hiked again in February 1995, yet the S&P 500 fell just 1% in 1994 and returned almost 34% in 1995.

"I don't think there's a set formula that works in all times," noted Don Hays, president of Hays Advisory Group. "Times change."

In some ways, it makes sense that the market would perform soundly in times of rising rates and struggle when interest rates fall because a hike suggests the economy is in a fairly robust condition while a cut is a reflection of sluggish economic growth.

Meanwhile, some argue that stocks do eventually respond to changes in interest rates but that there is typically a lag time of 6 to 12 months. Historically, some of the best years for stocks have come in the year after a series of rate cuts, observers say.

Inertia

Chris Wolf, an analyst at J.P. Morgan Private Bank, said it is "not uncommon for the fundamentals to take over" at certain points in the cycle, and for an economic recovery to be "self-sustaining," although he did offer one caveat.

"It is not a consistent story to talk about higher rates and massive multiple expansion, particularly where you expect earnings to be the driver," he said.

Banc of America Securities analyst Tom McManus believes the old adage "don't fight the Fed" is simply too simplistic and that other forces, particularly valuation, determine how the market performs.

The last time the Fed hiked rates back in 1999, stocks were "broadly very attractively priced," and so weren't negatively affected despite the fact that bond yields went from just under 5% to about 7% in early 2000. "Today stocks are much more expensive than they were three years ago," he said.

"The Fed is probably going to push up long bond yields when it starts to tighten. Then the question is how will stocks behave," he said. "If stocks are already down significantly, then the rise in long bond yields won't affect them much. But for everything that's worked over the past two years, particularly small- and mid-cap stocks, look out."