Please ensure Javascript is enabled for purposes of website accessibility

For Real Investors, the Fed's Rate Hike Doesn't Matter

By Alex Dumortier, CFA - Sep 16, 2015 at 1:26PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

For investors, trying to anticipate the timing or effect of the Fed's first rate hike is wasted effort.

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.

Source: DonkeyHotey. Re-published under a Creative Commons license.

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.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Dow Jones Industrial Average (Price Return) Stock Quote
Dow Jones Industrial Average (Price Return)
$31,261.90 (0.03%) $8.77
S&P 500 Index - Price Return (USD) Stock Quote
S&P 500 Index - Price Return (USD)
$3,901.36 (0.01%) $0.57

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning service.

Stock Advisor Returns
S&P 500 Returns

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 05/21/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.