As Sam Sees It: Where to Go When Rates Rise?

Sam Stovall  |

Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.

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EQ: The four weeks leading up to and immediately after the Fed’s announcement, saw the market rise almost 6 percent. We’ve come off those levels since at a similar pace. Did investors use that move to sell into strength and take some profits off the table?

Stovall: Yes, I think they pretty much squeezed out whatever they would get as a result of the Fed not tapering this month, and possibly waiting until December to do so. In addition, there are an awful lot of headwinds that investors still have to contend with. Most currently, we have the continuing resolution, which ends October 1. We then have the debt ceiling that has to be approved by the end of October, and in between all of this, we have unemployment trends as well as third quarter earnings to have to deal with. So I think investors are feeling that it’s a little too stiff of a headwind for them, and are taking some profits when they still can.

EQ: While the market has enjoyed an elevated market thanks to the Fed’s monetary policies the past few years, it’s hard to deny that it’s most likely coming to an end pretty soon. Based on the historical trends and current pace of performance, what are some sectors investors should look to avoid?

Stovall: History says, but obviously does not guarantee, that you probably want to stay away from the higher yielding areas. By that, I mean the Utilities, Telecom Services, Consumer Staples, and even to a lesser extent, the Healthcare and Financial Services. This is mainly because these areas have relatively high dividend yields. Also, when interest rates are rising, it’s usually because of the Fed’s funds rate going up and not based on the 10-year note exclusively rising.

So the concern is that Financials might have seen their day in the sun, and that’s why they might end up performing poorly. I think reasons why these groups typically take it on the chin are because they offer above average dividend yields and they have fairly high debt-to-capital ratios. So if you’re committed to paying out a fairly high dividend, but carry a lot of debt that will soon have to be rolled over at a higher rate of interest, that’s like trying to swim with lead weights in your pockets. It makes it very hard to tread water, and as a result, investors tend to bail out of these areas because they’re worried about the effect it will have on earnings.

EQ: Are there any asset classes or sectors that could actually stand to benefit from an environment of rising rates?

Stovall: Yes, actually on a sector level, the groups that have performed the best have been Information Technology because they usually pay a fairly low dividend yield and traditionally have had a fairly low debt exposure, so they’re not going to be affected by higher rates.

Energy and Materials tend to do fairly well because they’re regarded as inflationary hedges. Also, Industrials also do relatively well because rising rates usually accompany the entrance to the middle part of the economic expansion.

From an asset class basis, it probably is no surprise that the S&P GSCI Commodities index has performed the best in a rising-rate environment going back to 1976. Probably a little surprising is that the S&P 500 has also done relatively well. That’s followed by the NAREIT Equity Only index. Since May of this year, REITs have taken it on the chin, mainly because investors have been looking upon them as substitutes for bonds and looking only at their income paying abilities, not based on their capital appreciation potential because of the underlying properties that they own. So I think over an extended period, we might find that this might end up being a good time to be adding to your exposure in real estate.

EQ: In this week’s Sector Watch report, you also described the selloff in REITs as a possible example of high-frequency traders and correlation clustering.

Stovall: Somebody mentioned to me that investors are not necessarily focusing on the assets underlying each investment, but rather whether they move in lockstep or have relatively high correlation. So who cares if they are income-only or income-plus capital gains potential? “If they do show high correlation with one another, than let’s sell them when rates rise and buy them when rates fall.” So that could be an additional reason why investors bailed out of the REITs—because of their relatively high short-term correlation with other higher yielding asset classes.

EQ: The debt debate is heating up again as we get ready to head into October. How bumpy of a ride is in store for investors?

Stovall: Unfortunately, history offers us very few examples of government shutdowns. One in particular was the middle of December of 1995 through the first week of January 1996. The S&P 500 fell almost 4 percent during that period, but jumped more than 10 percent after the shutdown was concluded. So if we have a similar situation where investors are getting worried about the market falling as a result of the wrangling going on in Congress, I would say look upon it very carefully as a good buying opportunity for the coming year.

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