The Fed's Historic Rate Hike: A Stock Investor's Perspective

The Federal Reserve is widely expected to end the era of the zero interest rate today. Here's how stock investors should think about this historic action.

Alex Dumortier
Alex Dumortier, CFA
Dec 16, 2015 at 12:11PM
Investment Planning

No matter how financial markets react, today will be historic. At 2:00 p.m. EST, the Federal Reserve is expected to begin turning the page on the post-crisis era of free money, albeit gingerly, by announcing a quarter percentage point increase in the federal funds rate.

It is seven years to the day that the Fed lowered the rate to its "zero bound" (strictly, the target range is 0.00% to 0.25%), three months after Lehman Brothers' seismic bankruptcy.

Image source: DonkeyHotey. Republished under CC BY 2.0.

At the beginning of the month, Fed chair Janet Yellen said the first rate hike "will be a testament, also, to how far our economy has come in recovering from the effects of the financial crisis and the Great Recession."

The increase has been heavily telegraphed by policymakers: Prices in the Fed Fund futures market imply odds of a rate increase today of three-to-one (76%), according to Bloomberg. That may help to explain why U.S. stocks are higher in early afternoon trading on Wednesday, with the Dow Jones Industrial Average (DJINDICES:^DJI) and the S&P 500 (SNPINDEX:^GSPC) up 0.24% and up 0.40%, respectively, at 12:05 p.m. EST.

The Fed has had to maintain a tricky balancing act in asserting its full flexibility on the timing of the first rate hike, all the while trying give markets plenty of guidance to ensure a smooth takeoff.

At this stage, policymakers appear to be "all in" on an increase, and delaying it any further would send a message that they have no faith in the robustness of the U.S. recovery, damaging the Fed's credibility.

The low level of uncertainty regarding the outcome of the Federal Open Market Committee meeting appears to be hitting the CBOE Volatility Index, which is down 4.20%. The VIX is a closely followed measure of the market expectations for near-term volatility in the S&P 500; high values are associated with fear and uncertainty in the market.

Nevertheless, there is still enormous uncertainty, not regarding whether or not the hike will occur, but, first, with respect to the impact the hike will have on specific markets (the U.S. junk bond market and emerging markets come to mind) as well as on the longer-term path of rates. This is not your mother and father's tightening cycle.

In fact, the best historical comparison may date back to July 3, 1947, when the Fed announced it would let the yield on short-term Treasury securities rise (it had been fixed at 0.375% since 1942). As the following graph shows, U.S. stocks performed admirably over the following decade, more than tripling:

Is that a harbinger of good things to come for U.S. stocks over the next decade? Not so fast! In June 1947, U.S. stocks were trading at 11.1 times their average earnings over the prior 10 years. The equivalent multiple for the S&P 500 as of yesterday's close was 25.9, which looks a mighty headwind. Economic growth in the immediate post-war period was higher than it is expected to be now, too.

What does this mean for investors? Those who are expecting a 15% -- or even a 10% -- annualized return from a U.S. stock portfolio from current levels may want to temper their expectations. On a brighter note, the normalization of interest rates will enable fundamentals to reassert themselves as the primary driver of stock prices. As a result, we could be entering a period in which active managers (i.e., stockpickers) will shine.