Where Do We Go From Here?

Market’s Actions Post a Second Rate Hike

Short term, I’m very bullish on the stock market. We have, of course, the “January Effect”, a yearly phenomenon in which the market generally trades higher for the first 5 days of January. Then there’s the natural “End of Quarter Effect”, in which funds don’t want to appear underweight (especially when there’s a significant uptrend), so they buy stocks to make their year-end portfolio resemble a winning one. Add to this, the major portfolio rebalancing taking place, which was discussed in last week’s newsletter, and it’s easy to see why things should be fine for the next few weeks.

But, here at Tailwinds, except for our trading, we don’t typically focus on days or weeks. Most of our investments are in the small and micro-cap arena, and bringing a short-term perspective to this space is often a recipe for disaster. Therefore, the intent of this week’s newsletter is to look beyond the next few weeks and try to see what the longer-term future portends. It’s a good time to do so, because, having just had a rate increase, there’s significant empirical analysis to draw on to see what history tells us about 2nd rate increases and their effects on the market.

In this vein, I took a journey around the internet, looking for anyone who could provide a definitive forecast for the market. I’ve looked at lots of data this week. I’ve also read as many market prognosticators’ forecasts as I could handle, and generally spent a ton of time googling “market performance after a 2nd rate increase.” And, through this process, I’ve learned a lot.

For example, if you’re Ken Fisher, you’re paid to manage money for people. And, therefore, you believe a second rate increase is a buying opportunity…see below.

Fisher Investments

Fisher has shown that the period of 12-24 months after a rate increase there is a dramatically positive market trend of 12.6% on average. Now, I’m not one to argue with Fisher, as his track record is pretty darn good. But, perhaps he’s got some kind of selective bias here? I only mention this as I came across what I believe is a more inclusive data set that demonstrates dramatically different results.

MarketWatch

This chart from MarketWatch represents pretty compelling evidence that the market tends to stall out in the second year of a raising cycle. It contains all the years cited by Ken Fisher, but adds in a few more.

The most interesting thing about the conclusion drawn by MarketWatch is simply how dramatically different from that of Fisher. You have very strong results from one and very flat to weaker results from the other. Basically, I got down seeing these, and similar results, and realized that understanding how the market reacts to a 2nd Fed increase is a more complex question than I had realized when I set out to write this article.

This was truly confirmed for me when I dug deeper and started looking at trends that are associated with a rising rate environment. For example, I came across the following chart that shows market performance over the first 2 percentage points of Fed increases, irrespective of how long this took.

Returns in Rising Rate Environmnet

The best thing about the above chart is the title, “NO RULES”, which is a very accurate description of what I had learned so far. Because, as far as I could tell, a second Fed rate increase was a pure crapshoot for the market.

But, I kept looking. And, eventually, I came across the following.

TIAA-CREF

This analysis, from TIAA-CREF, throws in a whole bunch more variables, then tries to correlate it to the current environment. The most interesting part of their analysis here, is trying to understand the root cause of a Fed rate increase, and its effect on the market. And, there does appear to be a correlation here. In their words.

When the goal is to stop inflation, the Fed has to take aggressive action to slow the economy—often at the risk of causing a recession. When higher rates reflect an improving economy, the effect is more benign.

In general, hikes aimed at slowing high or rising inflation tended to hurt stocks. Hikes that rose at a measured pace—or reflected improving economic growth—tended to be more positive.

And, there you have it. I’m going with TIAA-CREF on this one. A second Fed hike has no real determining impact on the market. Instead, the reason behind a Fed hike correlates well with the market going forward. And, in our case, the Fed is raising due to a stronger (not great, but stronger) economy, and full employment. Therefore, based on the recent Fed increase, there should be no reason to fear market returns in 2017. There might be other reasons, but this just isn’t one of them.

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