Monday Morning: Fed’s hikes don’t always spook stocks

One of the factors keeping the market locked in a narrow trading range in recent weeks has been a fear that the next move by the Federal Reserve will be to raise interest rates. And, in fact, long-term rates have been trending upward.

It makes sense that an increase in interest rates should result in lower stock prices, all other factors remaining unchanged. The price of a stock, in a perfect world, theoretically is the present value of the future stream of dividends the company is likely to produce. If you could forecast that dividend stream accurately, you could value stocks accurately. And, of course, dividends are tied to earnings.

Today, when dividends are low – and many companies pay no dividends – investors often focus on earnings or cash flow as proxies for dividends in those calculations.

When interest rates rise, the present value of the dividend stream (or earnings or cash flow) declines; when interest rates fall, the present value increases.

Market rose, too

But according to a recent study by The Leuthold Group in Minneapolis, stocks don’t always fall when interest rates rise, especially when they rise in the early to middle stages of a recovery. The Leuthold Group examined five such periods of rising interest rates to see the impact on the stock market.

It found that during those five periods, which lasted an average of 54 weeks, interest rates increased by an average of 1.95 percentage points (or 54.2%). The Standard & Poor’s 500 stock index produced an annual compound return during the five periods of 20.1%, with the highest being 33.1% in the July 1963 to November 1964 period. The lowest was no gain, during the September 1977 to May 1978 period.

How can that be?

When the economy is at full flood, a Fed interest rate increase of any size usually kills the stock market. Why the difference when the economy is in the early stages of an expansion?

Again, the answer is earnings.

When the economy is near its peak and overheating, the next move in dividends or earnings is likely to be downward. Thus, earnings can’t grow fast enough to offset the effect of the rising interest rates on the present value of the earnings.

When the economy is in the early or middle stages of a recovery, earnings may increase fast enough that the present value of that future stream can increase, even though interest rates are increasing also.

The question is, what will happen this time if the Fed increases rates?

Is the economy recovering quickly enough to shrug off the interest rate increase and allow companies to generate earnings gains rapidly enough to produce an increasing present value, even as the discount rate rises?

Corporate earnings are the key. Are earnings likely to rise rapidly enough to overcome the rising interest rates?

So far, earnings reports have been disappointing, so an interest rate increase of any significance could hurt the market.

In addition, because of revelations about the manipulation of reported earnings by many companies, investors are uncertain about what true earnings are. Uncertainty usually raises the discount rate.

On the plus side, director of economic research Paul Kasriel and economist Asha Bangalore argue in their latest Northern Trust Co. economic commentary that for a number of reasons, Federal Reserve Board Chairman Alan Greenspan is likely to tread carefully with any interest rate increases.

They predict quarter-point increases each quarter from June 26 on, lower than what most Wall Street analysts expect. Among the reasons: Mr. Greenspan remembers the criticism of his excessive tightening in 1994-95, M2 growth has slowed, and oil prices already are imposing a tax on consumers.

My guess is that uninspiring earnings growth, combined with uncertainty about true earnings and modest Fed interest rate increases, will prevent any substantial gain in the market this year.

If your clients insist on increasing their market exposure, try to identify the sectors with the best earnings growth potential, and invest in mutual funds in those areas.

Mike Clowes is editorial director of InvestmentNews and sister publication Pensions & Investments.