The Federal Reserve's actions can have a marked influence on the economy and financial markets. For instance, some market analysts believe that the Fed's massive, multi-year bond-buying program coupled with a recordsetting period of near-zero interest rates fueled the six-year bull market for stocks. Now investors are awaiting news of when -- and by how much -- the Fed will raise short-term rates, and what that action might mean for stocks.1 While many market watchers have speculated about the effect of rising rates, history provides a window into how stocks have reacted to such policy shifts in the past.
A Look Back
Research that looked at the past 35 years (and six rate-hiking cycles) found that stocks don't necessarily follow a straight path up or down in reaction to a rate hike. Instead, they present a mixed bag of performance. For instance, analysis reported on CNBC.com found that in two of the six cycles, stocks, as represented by the S&P 500, were lower a year after the initial rate hike. Even so, the average gain for all six periods was 2.6%. And on average, a year and a half after the first rate hike in a cycle, the market was up 14.4%.2
What's Different This Time?
While heightened volatility is often a byproduct of the Federal Reserve initiating a rate hiking cycle, there are unique variables at play this time that may help to lessen the market's reaction.
First, with the federal funds rate set at 0% to .25% for nearly seven years -- far below its starting point for the previous several rate hiking cycles -- it is believed that the Fed has a lot of leeway to move rates up before creating a significant drag on the economy. Second, many economists and Wall Street analysts expect that when the Fed does begin raising rates for the first time since the Great Recession, it will do so slowly in an attempt to minimize market disruption.3
Considerations for Investors
Given the inevitability of an interest rate hike looming on the horizon, you may be cautious in your outlook for your stock portfolio. But don't let your emotions get in the way of potential investment opportunities. Consider discussing the following strategies with your financial advisor at your next meeting.
- Buy on the dips. If stocks do swoon when the Fed acts, many analysts feel the drop will be short-lived and may in fact prove to be a good time to selectively add to your portfolio. A systematic purchasing plan, also known as dollar cost averaging, can help in volatile times, as it provides for regular purchases over a period of time, taking the guesswork out of specific timing of purchases.4
- Consider high-quality dividend stocks. Equity investors looking to limit volatility may want to consider an income-producing strategy via dividend-paying stocks. Although a company can potentially eliminate or reduce dividends at any time, a dividend may provide something in the way of a return (i.e., income plus any potential price appreciation) even when stock prices are volatile.
- Review sector allocations. History supports the notion that Fed actions affect equity sectors in different ways. For instance, in a rate-hiking cycle, defensive sectors, such as utilities, energy, and consumer staples have tended to perform better, as these sectors produce necessary goods and services that have less reliance on consumer discretionary spending. In a rate-cutting cycle, leading sectors tend to be those that are more dependent on consumer spending, such as retail, autos, and construction.5
These are just a few of the investment strategies you may want to consider heading into a rate-hiking cycle. Work with your financial advisor to review your unique circumstances and make changes, as deemed appropriate, for your situation.
1 Investing in stocks involves risks, including loss of principal.
2CNBC.com and Nuveen Asset Management, "When the Fed raises rates, here's what happens," September 17, 2015.
3CNBC.com, "Wall Street history says stocks can survive Fed rate hike," September 15, 2015.
4Dollar cost averaging involves regular, periodic investments in securities regardless of price levels. You should consider your financial ability to continue purchasing shares through periods of high and low prices. This plan does not assure a profit and does not protect against loss in any markets.
5Forbes, "How Rising Interest Rates Will Affect The Stock Market And Your Investments," May 19, 2015.
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