May 28, 2015 Investment Education: Market declines when interest rates start going up.
Comment on the sharp decline in stock prices on May 26, 2015.
Sharp declines in the stock market, say 1% or greater and with weakness in the ratio of advancing stocks to declining stocks, are scary and leave investors indecisive. Is the decline the beginning of a long awaited correction, or just another of the sharp breaks we have seen many times in the current bull market? Here are my thoughts.
As a market observer and participant for many years, I note the often repeated pattern of a substantial market correction beginning when the Fed first starts to raise interest rates. In fact, many sharp market declines in the past two or three years have coincided with signals from the Fed, or other indications, or just wide-spread fear, that the Fed was about to start raising interest rates. As the Fed backed away from such talk, the bull market resumed.
In my view, the recent strength in employment, home prices, and other economic measures, suggests that the Fed can no longer look at the few remaining soft spots in the economy and say that interest rates need to remain near zero.
So if we assume, as I will, that the Fed will now begin to raise short term interest rates, is it time to sell stocks? or is this time different? First, with all the threats to raise rates in recent years, the pattern of interest rates up = markets correction, may no longer work. The forthcoming rise in interest rate has been expected for so long that it may be fully discounted by now.
Second, the underlying fundamentals remain strong. Specifically, the now clear end of high and rising energy prices – the so-called “energy dividend” – will continue to ripple through the world economy and undergird economic growth and profit margins. Another fundamental plus, although more controversial, is that the economy has much less to fear from President Obama. The market has managed to rise to new highs, albeit very slowly, despite Obama’s anti-business rhetoric, legislation, and threatened legislation. But without control of both houses of Congress, and with the media now embracing Hillary and Elizabeth Warren, it appears less likely that Obama can do any serious damage to the economy in his remaining time. And – a corollary – it is quite likely that Obama will be followed a president who is not as hostile to business as he is, creating a more favorable environment for stock prices. Despite these underlying and indeed powerful bullish factors, the market is at a relatively high, or record high price/earnings valuation, depending on whose numbers you use, which may fully reflect these bullish factors.
Therefore, my judgment is to go with history and reduce exposure to equities. While the market’s recovery of May 27 may indicate that the bull market is back on track, at least for now, remember that the Fed has not yet begun to increase interest rates. When this does occur, I expect we will see another sharp decline like May 26, and likely lasting longer than one day. When that occurs, do not be paralyzed by the sudden give back of some of your gains of recent days, weeks, and months. Raise some cash.
Since I am not prescient enough to say when the Fed will finally take concrete steps to raise rates, or exactly when the market will react to it, I plan to lock some profit in now – and sleep better at night.
Finally comment: History reveals that the correction that begins with the initial rise in interest rates is not necessarily the end of the bull market. But the correction can last for many months and exceed a 20% decline. So being on the sidelines with some dry powder is not a bad thing!