So What if Fed Raises Rates? Here’s What

Will they or won’t they raise interest rates?

That was the question that consumed Wall Street all last week--and the uncertainty sent the Dow Jones industrial average yo-yoing down and up and down and up again.

Yet the question investors should have been asking was: So what?

At the risk of egging the Fed on, so what if, as many now expect it to, the Federal Reserve’s policymaking Federal Open Market Committee goes ahead and raises short-term rates to nip inflation in the bud?

Certainly, bad things can happen to stock prices when rates spike up.

For one, high interest rates tend to make bonds a more attractive alternative to stocks, driving investors on the margins away from the equity markets. For another, high rates jack up the cost of capital, which has a deleterious effect on economic growth.

And the more it costs to grow and expand business, the less companies can. (And without growth in revenues and profits, is there any reason to expect companies’ stock prices to rise?)

But hasn’t the market already accepted the eventuality of a rate increase?

As Salomon Smith Barney’s Steven Weiting argues in a recent report: “A single 25-basis-point [or 0.25-percentage-point] tightening move this year appears to be at least partly priced into current equity market valuations.”

Since May 13--just before the consumer price index, a key inflation barometer, shot up, leading the Fed to “tilt” in favor of raising rates--the yield on the benchmark 30-year Treasury bond has risen from 5.75% to just a hair under 6% (there’s your 25-basis-point spike).

Since then, the benchmark Standard & Poor’s 500 index of blue-chip stocks has fallen as much as 6%, before recovering slightly late last week, and the Nasdaq composite index has fallen nearly 8%. Given all this, many market strategists now expect one of two scenarios to play out:

1) The Fed, in light of the recent correction in stock prices and Friday’s somewhat reassuring news concerning inflation, decides to leave rates alone for now (which would be great news for stocks).

Or . . .

2) The Fed goes ahead and raises rates, but only a quarter of a point. And only once.

Notes Alan Skrainka, chief investment strategist for St. Louis-based brokerage Edward Jones: “We believe the odds are increasing that the Fed will follow through with an increase in rates at its next meeting June 29-30.” But, he adds, “there’s every indication that if the Fed acts, it will prudently move to tap on the brakes with a single rate increase.”

Either way, “investors should not be overly concerned,” Skrainka argues.

Why? With the notable exception of September 1987, just before the Black Monday crash, the stock market has tended to rise (not decline) in the weeks and months following a single rate increase. (The same can’t be said for a series of three or more rate hikes.)

In fact, in the 20 times the Fed has raised rates in isolated instances between December 1917 and the present, the S&P; 500 has risen, on average, nearly 9% within the following 252 days. That may not sound great, but remember: On average, stocks have historically risen about 10% a year.

“It’s a very closely guarded secret,” Skrainka says. “Many economists, strategists and gurus would have you believe that if the Fed hikes rates, or announces a bias toward tightening, that it’s a disaster.”

But that’s just not the case.

So what does this mean for investors?

“As long as the Fed is operating on the margins, clipping here or snipping there,” says Joseph Battipaglia, chief investment strategist at Gruntal & Co. in New York, “the overall picture doesn’t change.”

Nor should your long-term stock strategy change that much, Battipaglia argues.

That’s why Battipaglia continues to recommend, as he has for a while, giving consideration to pharmaceutical and financial stocks (and funds that invest in them), despite the conventional wisdom that says rising rates will disproportionately hurt banks, brokerages and asset managers.

In a similar vein, other analysts argue that you shouldn’t feel compelled to pull the plug on your utilities, just because of rising rates.

True, utilities have traditionally been considered bond substitutes, which meant that in periods of rising rates (and thus falling stock prices), utilities were something to avoid. But this time around, although the Dow Jones industrial average has seesawed in recent weeks on rate-hike fears, the Dow utilities average has risen, hitting an all-time high on Friday.

Hugh Johnson, chief investment officer at First Albany Corp. in New York, believes this is the market’s way of saying that what matters more, leading into this potential rate hike, is a stock’s valuation, not its sensitivity to interest rates.

This means that if you are going to tweak your investments slightly, you may want to start by lightening up on funds that invest in stocks with high price-to-earnings ratios. “You don’t want to own high P/E stocks right now,” Johnson says. “That’s the worst place to be.”

Adds James Stack, editor of InvesTech, a market newsletter published in Whitefish, Mont.: “This isn’t the time to go bottom fishing in Internet stocks.”

OK, but what about interest-rate-sensitive stocks and sector funds that invest in them?

While it’s true that financials and utilities, for example, have historically been punished in periods of rising rates, it’s not always the case.

Consider the last three periods when the Fed tightened repeatedly (Dec. 31, 1981 to June 30, 1982; June 30, 1986, to Nov. 30, 1986; and April 30, 1994 to Oct. 31, 1994). In two of the three time periods, utility stock mutual funds gained more than 5%, according to fund tracker Lipper Inc. Financial sector funds fared worse, but they did rise in one of the three periods.

In fact, among small and medium-size stocks, a recent study by Prudential Securities found, utilities and interest-rate sensitive real estate investment trusts represented two of the three best-performing sectors during those three recent periods of Fed rate hikes.

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Times staff writer Paul J. Lim can be reached at paul.lim@latimes.com.