Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
EQ: What were your thoughts on the Federal Reserve’s assessment of the economy, and the subsequent sell-off in the Treasuries market?
Stovall: It’s interesting that whenever you watch the stock market numbers as Federal Reserve Chairman is speaking, you can see right away whether the market likes or dislikes what he has to say. So when Chairman Bernanke was recently addressing Congress, bond prices began to fall, and yields started to rise. It was the case not only with Treasuries, but also with investment-grade and high-yield corporate bonds. That indicated to me that one of the reasons that investors were selling out of bonds was because Bernanke was saying the U.S. economic growth was improving, and that not only would we not need additional stimulus in the form of a third round of quantitative easing, but that possibly, the Fed might be forced to raise short-term interest rates sooner than the already-stated target of late 2014. Basically, investors were trying to do as much reading between the lines as possible, and the reading that they saw indicated, rightly or wrongly, that the next move in interest rates is likely to be higher and not lower.
EQ: Investors typically associate lower interest rates from the Federal Reserve as being good for the stock market. Can you discuss why that isn’t necessarily true for all cases?
Stovall: There’s an old saying coined by market analyst Edson Gould that states, “two tumbles and a jump.” What this means is that whenever short-term interest rates have tumbled twice, the market then takes off. On the flip side, there’s, “three steps and a stumble”. And what this means is that once interest rates have moved up three successive times, then the market tends to stumble. What I did though, was I went back to 1953 and looked at monthly changes in the yield of the 10-year note. I then set up the premise to see how the S&P 500 performed for the month whenever we had a monthly rise in interest rates. I also tried to break out the data based on different interest rate zones: zero percent to 3 percent, 3 percent to 4 percent, 4 percent to 5 percent, and so on. What I found, interestingly enough, was that the average price change for the S&P 500 remained positive up until the 6-percent mark in the 10-year yield. So the line in the sand appeared to be at 6 percent, above which the market tended to fall on average, but below which the market tended to continue to advance. So if interest rates were rising but they were still below that line in the sand of 6 percent, stocks would still advance, essentially saying that it’s going to take the good with the bad. The good being an improvement with the overall economy, and the bad being higher interest rates in an attempt to possibly slow the economic growth or to counterbalance the potential increase in inflation.
Actually, I found that there was a “sweet spot” of between 3 percent and 4 percent when the market tended to rise 1.7 percent on average. Whenever rates were on the rise between zero percent and 3 percent, the market gained 1.2 percent on average. After that, when it rose between 4 percent and 5 percent, the average gain was 1.3 percent, and the market was less optimistic between 5 percent and 6 percent, and then slipping into negative mode beyond the 6-percent level. So whenever interest rates were rising between 3 and 4 percent, that tended to be the best time for equity price appreciation.
EQ: You also found a similar correlation with P/E ratios as well. Can you tell us about that?
Stovall: That’s correct. I looked at whenever we had interest rates at less than 3 percent, and then for every one-percentage point increase from there. I found that the P/E ratio for the S&P 500 on average rose from 13.1 whenever we were 3 percent or lower, to as much as 22.5 whenever interest rates were between 5 percent and 6 percent. Once we got beyond that 6-percent level, the average multiple did a stair-step decline. Once we hit 9 percent, the average P/E in the S&P 500 fell below 10 and into single digits.
So the takeaway is that the willingness of investors to pay up for earnings in the form of a higher P/E ratio, has a sweet spot at the 5 percent to 6 percent level. Also investors are still willing to pay up for earnings above that level. However, once we get too far out of the range or too high in terms of interest rates, then the market does tend to contract and investors are only willing to pay single-digit P/Es when interest rates go above 9 percent.
EQ: As expected, cyclical sectors have outperformed defensive sectors when the market rises. Which sectors tend to perform best when rates are rising in that desired range?
Stovall: Going back to that sweet spot range of 3 percent to 4 percent on the 10-year note, the sectors with the best average monthly price changes were Information Technology, up 4.6 percent, as compared with the S&P 500’s 3.0 percent. The second-best performer was Consumer Discretionary at 3.9 percent, followed by Materials and Financials, gaining 3.6 and 3.5 percent, respectively. What was also interesting was all 10 sectors posted increases when rates were rising in that 3 percent to 4 percent sweet spot. Hence the old saying, “A rising tide lifts all boats.” But it was your traditional defensive sectors: Consumer Staples, Telecom, Healthcare and Utilities that posted the weakest price performances. Utilities were up 2.6 percent, Healthcare was up 2.3 percent, Telecom was up 1.7 percent, and finally Consumer Staples was up 1.0 percent. So even though all 10 sectors posted increases on average, the cyclical sectors tended to beat the market, whereas the defensive sectors tended to underperform the market.
EQ: Does the timeframe for when interest rates rise also have an impact on the performance of the market?
Stovall: The speed with which interest rates rise is not really factored into my analysis, but obviously the question that a lot of investors have is whether this time will be different, because we’ve been hovering around the zero-rate levels for quite a number of months, if not years. Rarely have we started in the zero interest rate environment as we have today. In some ways, it is uncharted territory. The second question depends on how quickly interest rates advance. Will investors continue to stick steadfastly with stocks until reaching the 6-percent level? Or will they start to get scared once interest rates move beyond that sweet spot. So it does depend on how quickly we get there, because the faster we get there, the more unnerving, in my opinion, the move would be toward investors. I think investors would prefer a very low, gradual increase to interest rates.
The analogy is similar to that of a frog in water. If the frog warms up along with the water, it is able to stand at warmer water for a longer period of time, and even become frog soup. Whereas if you simply drop the frog into a pot of very hot water, it might end up jumping out before it does any permanent damage.