The Best Way to Prepare for a Fed Rate Hike
As you may know, the Federal Open Market Committee will meet on March 14 for two days to decide whether or not to raise interest rates for the third time in three years.
Strong economic data have strengthened the case for a hike. And the odds of an increase at this month’s meeting have jumped to 88%.
Stocks have enjoyed a euphoric rally since Donald Trump won the White House.
But over the next few weeks, a major question will take shape in the minds of investors.
Can the rally continue in the face of rising rates?
Senior analyst Jonathan Rodriguez provides a compelling answer below.
You might be surprised by his analysis.
Ahead of the tape,
Chief Investment Strategist, Wall Street Daily
The Bigger They Are, the Harder They Fall
If interest rates rise, stocks are doomed.
At least that’s the prevailing sentiment shared amongst many investors.
And while a rising rate environment tends to temper stock returns versus periods of falling rates, not all stocks feel the pinch equally.
In fact, I pointed out more than a year ago that rate hikes actually give a certain cohort of stocks a substantial boost.
I’m talking about small-cap stocks.
Indeed, while most people regard small-cap stocks as risky, they actually outperform “safer” large caps after an interest rate hike.
According to data from Fidelity, during periods of a falling 10-year Treasury yield, large-cap stocks outperformed small-cap issues by an average of nearly 1% (12.11% versus 11.37%).
On the other hand, their analysis — which spanned three decades — showed that small stocks led large caps during periods of rising yields on the 10-year UST (13.94% versus 13.38%).
But just why do small caps outperform during hike cycles?
It’s simple, really…
Small Caps Live Long and Prosper
An interest rate hike usually coincides with a healthy, growing economy.
And when rates rise, the dollar tends to follow. That is because the rate hike attracts foreign investors seeking higher returns on their capital.
Above all, a strengthening dollar means more purchasing power for Americans — namely, cheaper imports. And the overwhelming majority of small-cap companies generate sales in America.
The flip side here is that a stronger dollar makes exports more expensive for foreign buyers — who, in turn, often buy less.
This pinches the profits of companies that do business overseas, as many large-cap firms do.
Now, here’s where things get really interesting…
In the last rate hike cycle, which lasted from 2004–06, the Russell 2000 small-cap index rose 22.5%. That’s double the rise of the S&P 500 in the same period.
But small-cap value stocks led growth. They blasted 26% during the cycle, versus an 18% gain on the small-cap growth index.
At the same time, large-cap value names fell 1.1% and large-cap growth companies rose just 1.6%.
In other words, investors sold off “expensive” stocks and piled into “cheap” names — and shed international exposure for homegrown profits in small caps when rates rose.
This trend is playing out once again, and here’s how you can play it…
The Easy Way… and Profitable Road Less Traveled
All stocks tend to drop immediately following a rate hike. But over the life of a hike cycle, stocks tend to rebound sharply in the three–six-month period following the first hike — and steadily gain from there.
Since the first hike of the current cycle on Dec. 16, 2015, the small-cap Russell 2000 Total Return Index has gained 23% — versus an 18% rise in the large-cap S&P 500 Total Return Index.
Small-cap value stocks dropped 12% in the three-month period following the December 2015 hike, but rose 3% after six months.
But one year after the first hike, these issues were up 12.3%.
Bottom line: If the FOMC raises rates this month… buy the dip in small-cap value — and don’t look back.
The easiest way to trade this group of stocks is the low-cost, liquid iShares Russell 2000 Value ETF (IWN).
But if you’re after the pure plays — and the fatter returns that go with them — stay tuned.
I’ll spotlight one such small-cap value play next week.
On the hunt,
Senior Analyst, Wall Street Daily