U.S. EQUITY RESEARCH
Sector Watch
March 13, 2017
Sam Stovall
Chief Investment Strategist
CFRA
Author of
The Seven Rules of Wall Street
One New York Plaza
th
34 Floor
New York, NY 10004
(646) 517-2993
[email protected]
THREE STEPS AND A STUMBLE?
Stocks Usually Tumble Prior to, or Early in, a Rate-Tightening Cycle
On Wednesday, March 15 -- the Ides of March – many on Wall Street (ourselves included)
believe the Federal Open Market Committee (FOMC) will announce their third increase in the Fed
funds rate in the past 15 months (the first was on 12/16/15). Many (ourselves not included) also
believe that the market’s softening ahead of this pending rate announcement is merely a
precursor to a long-awaited decline of 5% or more that will be triggered by this third rate hike,
citing Edson Gould’s classic rule of “three steps and a stumble.” However, we believe that a
boxer is rarely felled by the punch he expects, as the Fed has been telegraphing their desire to
raise rates for quite some time. In addition, history indicates that stock market declines have
typically occurred in anticipation of the first rate increase, or shortly thereafter, due to the
uncertainty surrounding the ultimate magnitude and duration of that rate-tightening cycle. So
while we think stocks could fall by 5%+ at any time, we don’t think a selloff will be triggered by a
rate hike likely to be announced at the conclusion of this Wednesday’s FOMC meeting. Finally,
history also implies that when this rate-tightening cycle has come to an end, the Fed will have
raised the Fed funds rate by a total of approximately 2.25 percentage points.
Post-Hike Equity Actions
The Fed has initiated 17 rate-tightening cycles since WWII, based on the discount rate from 1946
through 1989 and the Fed funds rate thereafter. Rate hikes per cycle have been as few as one on
three separate occasions (1971, 1984 and 1997) and as many as 17 in 2004, with the average for
all rate-tightening cycles being slightly more than five hikes. Magnitudes of cumulative rate
increases have been as
S&P 500 Declines of 5%+ Starting Within Six Months of First Rate Hike or
little as 25 basis points
After Each of the First Three Rate Hikes Since 1946
to as much as 7.75
Decline >5% S&P 500 Declines >5% After Hike
Rate Hikes*
percentage points, with
First
Last
Total Before/During
#1
#2
#3
the average at 2.23
04/25/46 01/16/53
5
-(28.8)
(20.6)
-points. More important, 04/15/55 08/23/57
7
(6.8)
--(10.6)
the market typically 09/12/58 09/11/59
5
----didn’t wait until the third 07/17/63 12/06/65
3
-(6.5)
--3
(10.1)
---rate hike to stumble in 11/20/67 04/19/68
2
(5.6)
(36.1)
--price. Indeed the S&P 12/18/68 04/04/69
1
(13.9)
---500 fell either in 07/16/71 07/16/71
01/15/73 04/25/74
1
-(48.2)
--anticipation
of,
or 08/31/77 02/15/80
14
(19.4)
---slightly after, the first 09/26/80 05/05/81
4
-(5.3)
(27.1)
-rate hike 16 of 17 04/09/84 04/09/84
1
(14.4)
---3
(7.9)
(33.5)
(7.0)
-times, declining an 09/04/87 02/24/89
7
-(8.9)
--average 10.6% ahead 02/04/94 02/01/95
03/25/97 03/25/97
1
(9.6)
---of the first hike and
06/30/99 05/16/00
6
(6.3)
(12.1)
-(9.2)
22.4% after the first. 06/30/04 06/29/06
17
(8.2)
---The market slipped 12/16/15
???
3
(14.2)
--???
only
three
times
Averages
5
(10.6)
(22.4)
(18.2)
(9.9)
following second rate Source: CFRA, Federal Reserve. Past performance is no guarantee of future results.
*Discount Rates were used prior to 1989, while Fed funds were used thereafter.
increases and only Decline started within two weeks prior to first rate hike.
This report is for information purposes and should not be considered a solicitation to buy or sell any security. Neither CFRA nor any
other party guarantees its accuracy or makes warranties regarding results from its usage. CFRA, the CFRA inverted pyramid logo,
and STARS are registered trademarks of CFRA. S&P GLOBAL™ is used under license. The owner of this trademarks is S&P Global
Inc. or its affiliate, which are not affiliated with CFRA Research or the author of this content. Copyright © 2017 CFRA. Redistribution,
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twice after the third. Therefore, history implies that the Fed’s current gradual pace of minor rate
increases is likely already baked into stock prices.
Terminal Fed-Funds Level
One question many investors now have is “by how much will the Fed raise rates in this cycle?”
Well, if history is any guide, for we know it’s never gospel, the magnitude of cumulative rate hikes
has equaled 107% of the positive year/year % changes in CPI at the start of that rate tightening
cycle. In other words, since core CPI had risen 2.1% on a year-over-year basis as of December
2015, history implies that the Fed will hike rates by a total of 2.25 percentage points when this
cycle has come to an end. In terms of duration, we believe that the Fed funds rate will be
between 1.25%-1.50% by December of this year, and that this rate-tightening will conclude by the
end of 2018 or shortly thereafter.
Sectors Returns During Rising Rates
Finally, investors frequently ask “which sectors tend to outperform during a rate-tightening cycle.”
Traditionally, sector returns have been a reflection of the response by the 10-year yield to rate
increases rather than to the raising of the discount or Fed funds rates. Higher 10-year yields have
usually given higher dividend paying sectors -- such as consumer staples, real estate, telecom
and utilities -- greater income competition, causing them to underperform the overall market.
SECTOR WATCH
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On the other hand, more cyclical groups like consumer discretionary, industrials and technology,
along with the commodity linked energy and materials sectors, have posted above-market
average returns.
Financial stocks have also typically underperformed, possibly due to the inclusion of REITs, as
well as the impact of shrinking net interest income that typically occurred in a rising-rate
environment. One reason could be the -0.70 correlation between Fed funds rate and the yield
curve (10-year yield minus the Fed funds rate), meaning that when short-term rates rose, the
difference between long and short rates typically fell as inflation fears lessened.
This time, financial stocks have soared. Reasons may be two-fold, in our opinion. First, this sector
is responding to the new President’s pledge to reduce onerous regulatory pressures on the
sector. Second, this time the Fed’s rate-tightening efforts are designed not to “restrain,” but to
“recalibrate” the relationship between rates and inflation. Historically, the Fed funds rate has
averaged about 1.50 percentage points above the year-over-year rise in headline inflation since
1948 and core CPI since 1959. Today, this relationship would imply that the Fed funds rate
should be closer to 3.8%, than the current sub-1.0% area. Therefore, investors likely believe that
the yield curve will steepen because of a strengthening economy, which would ultimately benefit
the profit margins’ of those companies that “borrow short” and “lend long.”
So there you have it. The Fed meeting will conclude with a likely 25 basis-point increase in the
Fed funds rate. We don’t see stocks slipping in response, unless they raise rates by 50bps+ or
subsequently sound a much more hawkish tone, which we don’t expect. Finally, we are
maintaining our overweight recommendations on the industrials and materials sectors, while
keeping an underweight exposure to consumer staples, energy, real estate and utilities.
SECTOR WATCH
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Glossary
Required Disclosures
★★★★★ 5-STARS (Strong Buy):
Total return is expected to outperform the total return of a relevant
benchmark, by a wide margin over the coming 12 months, with
shares rising in price on an absolute basis.
★★★★☆ 4-STARS (Buy):
Total return is expected to outperform the total return of a relevant
benchmark over the coming 12 months, with shares rising in price
on an absolute basis.
★★★☆☆ 3-STARS (Hold):
Total return is expected to closely approximate the total return of a
relevant benchmark over the coming 12 months, with shares
generally rising in price on an absolute basis.
★★☆☆☆ 2-STARS (Sell):
Total return is expected to underperform the total return of a
relevant benchmark over the coming 12 months, and the share price
not anticipated to show a gain.
★☆☆☆☆ 1-STAR (Strong Sell):
Total return is expected to underperform the total return of a
relevant benchmark by a wide margin over the coming 12 months,
with shares falling in price on an absolute basis.
CFRA Ranking Definitions:
Overweight rankings are assigned to approximately the top
quartile of the asset class.
Marketweight rankings are assigned to approximately the second
and third quartiles of the asset class.
Underweight rankings are assigned to approximately the bottom
quartile of the asset class.
S&P Capital IQ Quality Ranking
Growth and stability of earnings and dividends are deemed key
elements in establishing S&P Capital IQ earnings and dividend
rankings for common stocks, which are designed to capsulize the
nature of this record in a single symbol. It should be noted,
however, that the process also takes into consideration certain
adjustments and modifications deemed desirable in establishing
such rankings. The final score for each stock is measured against a
scoring matrix determined by analysis of the scores of a large and
representative sample of stocks. The range of scores in the array of
this sample has been aligned with the following ladder of ranking.
A+ Highest
A High
A- Above Average
B+ Average
B Below Average
B- Lower
C Lowest
D In Reorganization
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