That’s the conventional wisdom (read: old wives tale) about Fed rate hikes and the stock market. The idea is that the market absorbs the first two hikes in any rate rise series as if nothing were going on …but reacts negatively on the third.
The third in this series of rate hikes will almost certainly come tomorrow.
The problem with this particular old saw is that there’s very little evidence from the past to support it. Yes, there may be an immediate knee-jerk reaction downward. But in almost all cases the S&P 500 is higher a year after a third hike than it was on the day of the rate rise. Sometimes, the S&P has been a lot higher, once in a while a percent or two lower, but there’s no third-hike disaster on record.
Generally speaking, the reason is that rate rises occur as a policy offset to the threat of the runaway inflation that can happen during a too-rapid acceleration in economic growth. As financial instruments, stocks face downward pressure as higher rates make cash a more attractive investment option. On the other hand, strong earnings growth exerts contervailing upward pressure on stock prices. In most cases, the two effects more or less offset one another. (Bonds are a different story. With the possible exception of junk bonds, all the pressure is downward.)
Of course, nothing having to do with economics is that simple. There are always other forces at work. Usually they don’t matter, however.
In this case, for example:
–I think of a neutral position for the Fed Funds rate as one where holding cash gives protection against inflation and little, if anything, more. If so, the neutral Fed Funds rate in today’s world should be between 2.5% and 3.0%. Let’s say 2.75%. Three-month T-bills yield 0.75% at present. To get back to neutral, then, we need the Fed Funds rate to be 200 basis points higher than it is now.
I was stunned when an economist explained this to me when I was a starting out portfolio manager. I simply didn’t believe what she told me, until I went through the past data and verified what she said. Back then, I was the odd man out. Given the wholesale layoffs of experienced talent on Wall Street over the past ten years, however, I wonder how many more budding PMs are in the position I was in the mid-1980s.
–the bigger issue, I think, is Washington. I read the post-election rally as being based on the belief that Mr. Trump has, and will carry out, a mandate to reform corporate taxes and markedly increase infrastructure spending. The Fed decision to move at faster than a glacial pace in raising interest rates is based to a considerable degree, I think, on the premise that Mr. Trump will get a substantial amount of that done. If that assumption is incorrect, then future earnings growth will be weaker than the market now imagines and the Fed will revert to its original snail’s pace plan. That’s probably a negative for stocks …and a positive for bonds.