Will a Fed rate hike kill your stock portfolio?

Will a Fed rate hike kill the stock market? History says no

Even more than the Greek fiscal crisis, the biggest near-term threat to the stock market today is widely thought to be the prospect of an interest rate increase by the Federal Reserve.

Tea-leaf readers will be polishing their lenses again in preparation for this week's meeting of the Fed's rate-setting Open Market Committee meeting, though expectations are that the nation's central bankers will wait until September to raise rates rather than do it now. 

Whatever the exact date may be, the strength of the economy and the level of job growth have most market watchers figuring that some rate hike is almost certain before the end of 2015. The stock market has thrived during the low-rate environment of recent years--since the Fed's last rate cut on Dec. 16, 2008, the Standard & Poor's 500 index has gained roughly 140%--so it's reasonable to ask if the party's about to be broken up.

The emerging consensus of market gurus, however, is that there's no cause for panic. In fact, history suggests that a period of rate increases tends to set the foundation for a strong bull run. Consider the countervailing arguments: The bear market case is that higher interest rates will make stock yields fall relative to bonds and also cut into corporate profits; the bull market case is that the Fed raises rates when the economy is strong and that moderate growth (one goal of a tightening policy) is good for stocks.

Here's Josh Brown of Ritholtz Wealth Management and the Reformed Broker website, crunching the numbers recently in Fortune

"In the one year period leading up to a rate hike cycle, the S&P 500 has done significantly better than the typical 12-month rolling period, with an average return of 18.11% versus 11.6%.

"In the one year period following the final rate hike of a cycle, the S&P 500 has also done better, with a return of 14.6% on average.

During the rate hike cycles themselves, stocks typically do worse than average but still manage to earn positive returns for investors. The S&P 500 has posted a weighted average compound annual growth rate (CAGR) of 8.3% during the eight rising rate periods of the last four decades. And volatility has actually been lower than normal during six of these eight periods."

Brown also cites an analysis from Merrill Lynch finding that stocks do particularly well during rate-hike cycles with very low starting points, which is the case now. The Merrill Lynch team also finds that, on average, the worst period for equities is the six months preceding a rate hike. That seems to be true this time around, too: so far in 2015, the S&P has gained a dismal 1.3%.

Much of the hand-wringing over an imminent rate increase may stem from a couple of historical events: a surprise hike in October 1979 under Fed Chair Paul Volcker, and a hike in September 1987 that preceded the October 1987 stock market crash by a little over a month.  

But the more important lesson is that every period is different. Stocks respond to so many variables--demographic, financial and economic--that picking out any one factor and judging it to be the key is a dangerous, and ultimately unprofitable, game. The factors in play today include a historically high valuation for stocks, fiscal instability in Europe, historically low interest rates, and early signs of economic growth after a grindingly long recession. The first two of these look like negatives, the latter two like positives. And there are many other factors that could come into play.

The upcoming rate hike may be one that crashes the stock market. Or maybe it won't. Brown may have put his finger on the one relative certainty about the approaching rate hike: "There is no doubt that you will continue to be inundated with opinions, scare tactics and all sorts of other noise the closer we get."

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