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: All eyes were focused on the Fed this week as the market braced for the latest FOMC statement and a press conference from Fed Chair Yellen. The market seemed to get the two most important words it was looking for. What’s the implication going forward for the eventual rate hike?
Stovall: First off, I think most of the Fed watchers were thinking that the Fed would remove the “considerable time” phrase, but the Fed decided to keep it in, emphasizing that changes to their monetary policy were going to based on data, not dates
What this tells us is that they’re most likely going to wait to raise rates until after the ongoing economic reports bring them to that conclusion. I think that the implication is that the Fed is in no hurry to raise rates. It also realizes the damage it could do to the U.S. debt level because of all of the debt that the U.S. it currently has will need to be eventually rolled over.
Going forward, I think most people will still be arguing whether the first rate increase will occur in the end of the first quarter in the March meeting where they have a press conference, or wait until the second quarter when they also have a Fed meeting and an accompanying press conference.
EQ: As you noted in this week’s Sector Watch, the expectation for the first rate increase was for late second quarter of 2015. It seems like some are trying to creep that date up a bit to get ahead of the curve. Is this just another example of investors trying to out-anticipate each other?
Stovall: Pretty much. I think the majority of investors realize that the next move for interest rates is most likely to be higher. We can tell the direction it’s going to go, we just can’t tell both the timeframe and the direction. So people are trying to out-anticipate when that timing will actually take place.
If we are within six months of the first rate increase, then the market becomes increasingly vulnerable to a decline of 5% or more. Yet what Fed Chair Yellen may have just done is tell investors that we may actually be further than six months away, so we still have some time at our disposal to utilize these lower rates to help push equity prices higher.
EQ: There are some dangers in jumping the gun and making your moves too early. The six months leading up to and after the first rate hike seems to very a very vulnerable period for the S&P 500. Historically, what have we seen in terms of performance?
Stovall: What I found was that in the six months leading up to the first Fed rate increase was the time in which the market was most vulnerable. We had 16 times since World War II that the Fed engaged in a rate-tightening cycle, and in 13 of those 16 times, the market went through a decline of 5% or more with an average of just above 16%.
So the decline didn’t fully occur within that six-month period, but a topping out and beginning of a pullback or correction started within that six-month period and did not conclude until after the Fed started to raise interest rates.
I think it implies that the closer we get to the first rate increase, the higher the likelihood that the market will undergo a meaningful decline. Also, it’s important to remember that we’ve gone 36 months without a decline of 10% or more, which is three times the median timeframe and twice the mean. So no matter which way you look at it, we’re overdue.
EQ: In that sense, is the market set up like a spring where we’re wound very tight because of that extended period without a pullback or correction?
Stovall: I think what it shows is that it’s like pulling back on a crossbow or winding a spring—or whatever analogy you use—but basically the longer you go, the tighter the wind, and therefore the stronger the reaction. So that is a big concern because the four times since WWII where we went longer than the current 36 months, three of those four times the market fell into a new bear market rather than simply undergoing a regular correction.
EQ: How should investors approach this period in the market with regards to preserving their portfolio or even potentially benefiting from it?
Stovall: What investors need to do is to realize that interest rates are very low right now. There are relatively few alternatives to equities because earnings continue to climb, inflation remains low, and therefore forward equity growth expectations remain fairly elevated. In addition, higher rates do tend to be a negative for gold, and commodities in general go through a declining period, so I would be telling investors to not try to jump the gun or try to anticipate when the Fed is actually going to raise rates because it might end up being a very long time.
Interest rates could remain low for quite some time because even if the Fed does start to raise rates, our long bond rates are likely to remain low as the yield on the 10-year note still looks vastly more attractive than the yield on similar foreign bonds. In general, I would say that we are likely to be in a low-interest rate environment for quite some time, so don’t give up on the gains that you are likely to be receiving.
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