Two Key Points About the Fed’s Rate Hike
Thursday, December 17, 2015

Much of the chatter about yesterday’s interest rate hike by the Federal Reserve overlooks two key points. First, over the past 61 years, stocks have tended to rise during the 12-month period following the first rate hike. Secondly, it’s different this time.

Put asterisks by both of those statements.

I’ll start with the reassuring news. As we discussed in the December AAII Dividend Investing report, first rate hikes have been followed by higher stock prices over the following 12 months. Stocks have particularly risen when a rate-tightening cycle was started in response to economic growth. In the six 12-month periods starting in 1954 with core inflation at levels that TIAA-CREF characterized as low, stocks rose four times. Stocks rose every time when core inflation was low, bond valuations were high and interest rates were first raised.

Before you back up the truck, here is the asterisk. Though seemingly bullish for the current environment, the sample size is small. TIAA-CREF’s report, which was the most comprehensive one we saw, only covered 12 first rate hikes. Plus, the current trio of a first rate hike, low inflation and high bond valuations has only previously occurred in 1954, 1958 and 2004. So while the record is favorable, it’s not guaranteed to repeat.

Now onto the second observation: It’s different this time. Since at least 1954 (if not further back), the Federal Reserve has never raised rates from such a low level. The unwinding of the monetary stimulus may well be the subject of economic research and textbooks for years and even decades to come. That's not to mention that large banks are currently being required to meet tougher capital requirements and oil remains in the doldrums, having traded as low as $34.63 per barrel today.

But, it was also “different this time” during periods surrounding other first rate hikes. In 1954, the Korean War had recently ended and the Federal Reserve was just a few years past no longer having to monetize Treasury debt at a fixed rate. In 1972, Bretton Woods had recently ended and the Arab oil embargo ensued not too far afterward. In 1983, Paul Volcker was battling double-digit inflation. In 1998, the tech bubble was quickly enlarging. The point is that there are always events occurring that not only influence the decisions made by the Federal Open Market Committee (FOMC), but also how stocks and bonds perform after the rate hike tightening cycle begins.

What matters going forward is how the U.S. economy performs as well as the magnitude of future rate hikes and the pace at which they occur. The FOMC thought our economy is finally strong enough to withstand a rate hike, though inflation remains below its target.

Globally, economic growth remains weak. China is slowing, while Europe and Japan are stagnant. Commodity-producing countries continue to be adversely affected by weak oil, coal and metal prices. If these conditions continue, it would be easier for the FOMC to justify gradual increases in rates, which Chair Janet Yellen suggested yesterday would be the path going forward.

Rising prices are nice, but the magnitude of the price gains is also important. Periods of monetary tightening have been associated with lower-than-average gains in stocks prices. Small-cap stocks have been adversely affected more than large-cap stocks, but both have realized lower, though—and importantly—still positive, returns. The sample size is small and while history often rhymes, the future has a tendency of unfolding in ways we do not expect it to.

One final note, before you put any weight on a strategist’s or other “expert’s” forecast for what will happen next with interest rates or bond yields, consider how many such predictions about when the Fed would raise rates have been routinely wrong over the past approximately five years. Boasting about being right about calling yesterday’s rate hike is akin to claiming to have correctly forecast rain during a drought: do it enough times and eventually one of the forecasts will be right.

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AAII Model Portfolio Update

There are no rule changes to the Shadow Stock Portfolio, but an adjustment was made to the section on stock order guidance. Previously, when the need for liquidity was discussed, it was suggested that the average daily dollar volume of a stock should be at least four times the size of the position you wish to create. AAII founder and chairman James Cloonan now feels that this should be increased to 10 times the desired position size.

For example, if you wish to establish a position of $10,000 in a stock, then you should restrict choices to stocks with average daily volume equal to at least $100,000. This will make getting in and getting out of the stock much more efficient. Along those lines, James Cloonan requires an average daily volume of $300,000 for the stocks selected for the Model Shadow Stock Portfolio. This is why the number of stocks passing Cloonan’s screen is less than the number of stocks that qualify under the basic rules.

As the Model Shadow Stock Portfolio underwent its quarterly review at the end of November, Olympia Steel (ZEUS) was sold because it violated earnings probation. Two new stocks were purchased with the proceeds: Seneca Foods Corp. (SENEA) and Townsquare Media (TSQ). Twenty-nine stocks passed the Shadow Stock screen, but after applying our $300,000-a-day volume requirement we had 15 qualifying stocks to consider. Two of these stocks were already owned: Key Tronic Corp. (KTCC) and Rocky Brands Inc. (RCKY). CSS Industries (CSS), Salem Media Group (SALM) and Willis Lease Finance Corp. (WLFC) also passed the standard Shadow Stock screen at month end without the higher trading volume requirement. However, current holdings in the Model Shadow Stock Portfolio that do not meet the higher liquidity requirement will not be impacted. Qualified stocks are companies held within the Model Shadow Stock Portfolio that currently meet the initial purchase rules. (They are designated as “qualified” in the notes column of the Model Shadow Stock Portfolio table.)

Two stocks were placed on earnings probation after announcing their quarterly earnings: Ducommun Inc. (DCO) and Universal Stainless & Alloy (USAP). A stock is placed on earnings probation if its last 12 months' adjusted earnings from continuing operations are negative. If a subsequent quarter has negative adjusted earnings prior to 12-month earnings becoming positive, the stock is sold. 

No stocks in the portfolio approached the value limit (three times the initial 1.0 price-to-book-value filter) or the size limit (three times the initial $300 million market cap filter) at end of November. 

The AAII Model Shadow Stock Portfolio gained 0.9% during November and is now down 13.2% year to date. The AAII Model Fund Portfolio gained 0.5% during the month, cutting its year-to-date loss to 1.7%. In comparison, as of the end of November, the Vanguard Small Cap Index Fund (NAESX) is up 1.8% for the month and 0.4% for the year, the DFA US Micro Cap Fund (DFSCX) rose 2.8% for the month and is up 1.4% year-to-date, and the Vanguard S&P 500 Index Fund (VFINX) up 0.3% for the month and up 2.9% year to date.

The Week Ahead

The U.S. stock exchanges will close early, at 1:00 p.m. ET, on Thursday. The U.S. financial markets will be closed on Friday in observance of Christmas. Our offices will be closed on Thursday and Friday (December 24 and 25), and there will not be an Investor Update sent next week. On behalf of everyone at AAII, I wish you a merry Christmas.

Dow component Nike (NKE) on will report its quarterly results on Tuesday. Joining Nike will be fellow S&P 500 members Cintas Corp. (CTAS) on Monday and ConAgra (CAG), Micron Technology (MU) and Paychex (PAYX) on Tuesday. These will likely be the last earnings reports from S&P 500 companies released in 2015.

On the economic calendar, November existing home sales and the second revision to third-quarter GDP will be released on Tuesday. Wednesday will feature November durable goods orders, November personal income and spending, November new home sales and the University of Michigan’s final December consumer sentiment survey. Weekly initial jobless claims will be released on Thursday, as usual.

The Treasury Department will auction $13 billion of two-year floating rate notes on Wednesday.

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AAII Sentiment Survey

The percentage of individual investors expressing pessimism about the short-term direction of stock prices jumped to nearly a three-month high in the latest AAII Sentiment Survey. Optimism, conversely, fell to a five-month low. Neutral sentiment also fell.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell 4.6 percentage points to 23.9%. Optimism was last lower on July 29, 2015 (21.1%). This is the 39th out of the past 41 weeks with a bullish sentiment reading below its historical average of 39.0%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, fell 4.9 percentage points to 36.8%. This is a two-month low. Even with the drop, neutral sentiment is above its historical average of 31.0% for the 14th consecutive week and the 48th week this year.

Bearish sentiment, expectations that stock prices will fall over the next six months, spiked upwards by 9.5 percentage points to 39.4%. Pessimism was last higher on September 30, 2015 (39.9%). This is just the third time in 14 weeks that pessimism is above its historical average of 30.0%.

During the past two weeks, bearish sentiment has risen by a cumulative 18.2 percentage points, while neutral sentiment has fallen by a cumulative 12.6 percentage points. Bullish sentiment has also fallen, dropping by a cumulative 5.6 percentage points. Optimism is at an unusually low level (more than one standard deviation below its historical average), while pessimism is near the upper end of its typical range.

There isn’t a singular reason to explain the shift in sentiment. The major stock indexes, though ending the seven-day survey period essentially flat, are down month to date. Stock prices have experienced volatility; the S&P 500 has incurred intraday swings of 1.5% on six days this month. In addition to fretting about further declines in stock prices, some AAII members are concerned about corporate earnings, the pace of U.S. economic growth and geopolitics, as well as being frustrated with U.S. politics.

Keeping some AAII members optimistic, however, is the possibility of future price gains, the ability of the S&P 500 to continue trading near its record high, seasonal trends and better-than-forecast third-quarter earnings.

Most of this week’s survey responses were given before yesterday’s rate hike announcement by the Federal Open Market Committee.

This week’s special question asked AAII members how they thought the average consumer was faring relative to a year ago. Nearly 39% said the average consumer is faring better, though many clarified their responses by describing the average consumer as doing somewhat or a little bit better. Lower energy prices and, to a lesser extent, a better job market and wage growth were credited. Approximately 17% said the average consumer is faring about the same. Though energy prices are low, several of these respondents view prices on other goods and services as rising. Slightly more than 21% described the average consumer as faring worse. These respondents said higher prices and expenses—particularly for health care—and slow-to-stagnant wage growth were offsetting the benefit of lower energy costs.

Here is a sampling of the responses:

  • “Aside from current gasoline prices, consumers are basically marching in place.”
  • “More people are employed and gas prices are down.”
  • “Not as well. Prices are up, but income is down or steady.”
  • “Stealth inflation in products, especially health care, is eroding purchasing power.”
  • “A little better. Lower energy expenses leaves more cash available for discretionary spending.”


This week’s Sentiment Survey results:

Bullish: 23.9%, down 4.6 points
Neutral: 36.8%, down 4.9 points
Bearish: 39.4%, up 9.5 points

Historical averages:

Bullish: 39.0%
Neutral: 31.0%
Bearish: 30.0%
Take the Sentiment Survey.

Local Chapter Meetings
AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!