The Federal Open Market Committee convenes today for its much-anticipated September monetary policy meeting, the outcome of which will be announced tomorrow at 2:00 p.m. EDT. That perspective isn't unsettling equity traders for now, with the Dow Jones Industrial Average (^DJI 0.03%) and the benchmark S&P 500 index (^GSPC 0.01%) up 0.61% and 0.64%, respectively, at 1:15 p.m. EDT on Wednesday.
The enormous amount of time and energy analysts and investors are devoting to guessing when the first rate rise will take place is wasted. To see why, let's get back to basics.
Equity valuations -- for an individual stock or an index such as the S&P 500 -- are primarily a function of two factors: Earnings growth determines the stream of cashflows on which shareholders have a claim, while the required rate of return is necessary to discount those cashflows back to their present value.
The required rate of return can be broken down into two components: the risk-free rate and an equity risk premium, which is the additional return investors require as an enticement to invest in stocks instead of government bonds. A higher required rate of return implies lower stock values.
Let's imagine the Fed raises the Fed funds rate by a quarter percentage point tomorrow, and that this increase is passed on across the entire government bond yield curve. How does a quarter-point increase in the risk-free rate increase affect the value of the S&P 500?
To answer the question, we can use a spreadsheet put together by New York University's Aswath Damodaran, which allows you to value the S&P 500 based on your own assumptions (or, conversely, to back out the assumptions implied in the current index price). The spreadsheet is available freely here.
The answer, using Pr. Damodaran's honest assumptions and holding all other inputs constant, is that a quarter-point hike would reduce the value of the S&P 500 by less than 4% to roughly 1,900.
Of course, in financial markets, all other factors never remain equal. We don't know how a rate increase would impact expectations for earnings or the equity risk premium.
Changes in the latter could swamp the direct effect of the risk-free rate. The last few weeks have provided an example of this: According to data from Bloomberg, the risk-free rate (the 10-year Treasury note yield) has increased by more than a quarter of a point since Aug. 24, yet the S&P 500 rose 4.5% over the same period, as investors' risk aversion retreated from its August peak.
It's plausible that the market could react favorably to a rate hike, as it removes an element of uncertainty from traders' landscape.
As another academic, Jeremy "Stocks for the Long Run" Siegel, told CNBC yesterday: "I think uncertainty is hurting stocks more than an actual rate increase. [...] Even if we get a 25 basis point increase with dovish language, and a lower dot plot, I think we could have a stock market rally." A rally sounds a bit ambitious, but the term has no quantitative definition, after all.
For these reasons (and others), I agree entirely with Pr. Damodaran when he writes:
Over the last five years, we have developed an unhealthy obsession with the Federal Reserve, in particular, and central banks, in general, and I think that there is plenty of blame to go around. Investors have abdicated their responsibilities for assessing growth, cash flows and value, and taken to watching the Fed and wondering what it is going to do next, as if that were the primary driver of stock prices.
Western analysts and commentators have been scoffing at China's stock market recently, remarking that it is driven by government policy instead of stock fundamentals. This is the pot calling the kettle black! It's high time U.S. investors stopped fixating on the Fed and got back to the business of investing.