NEW YORK (MainStreet) — As interest rates are set to rise for the first time in nearly a decade, the reaction from the stock markets remain a large unknown factor for investors.
The Federal Reserve is expected to increase interest rates for the first time since 2006. Whether interest rates rise later in 2015 or early 2016, investors should prepare themselves to see equity prices decline and follow historical patterns of much smaller returns in their retirement portfolios.
During the period from 1966 to 2013, the S&P 500 returned 15.18% annually when the Fed lowered interest rates, compared to a 5.89% return when the Fed followed a restrictive monetary policy of raising interest rates, said Robert Johnson, president of The American College of Financial Services in Bryn Mawr, Pa.
How Equities Perform
Equities in most sectors tend to perform better when the Fed is lowering rates, but some sectors tend to perform well even when rates increase. The sectors that performed the “best in restrictive conditions were energy, consumer goods, utilities and food,” he said.
“These industries produce goods that are necessities, and it makes sense that the returns hold up better during restrictive monetary periods as people need to buy gas, toothpaste, heat their homes and eat irrespective of the monetary policy environment,” Johnson said.
When rates rise, the durable goods and auto sectors do not produce good returns, because “as monetary conditions are tightened and interest rates rise, people will delay buying a new washing machine or new car,” he said. Some mutual funds and exchange-traded funds have now created “sector rotation” funds that attempt to buy and sell out of various sectors depending on market and economic conditions.
Buying stocks in the financial sector, especially those of banks is tricky, said Matthew Tuttle, CEO of Tuttle Tactical Management in Stamford, Conn. Community banks and credit unions benefit the most, and these types of banks are “the first place to look when you think the Fed is ready to move,” he said.
Evaluating the outcome of larger bank companies is harder, because although banks generate a profit by borrowing at short-term rates and loaning them at longer term rates for businesses and consumers, the assumption that long-term rates will rise is a fallacy, Tuttle said. The other factors to consider are how much demand there is for loans and the higher credit standards.
Information technology, health care and the telecommunication services industries have outperformed the market since the end of WWII, Tuttle added.