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Remember the story of Chicken Little? It's a tale of courage over fear, an illustration of herd mentality -- and an analogy that fits current investor fears of an interest rate hike.
In the children's tale, Chicken Little concludes that an acorn which has hit her on the head is really the sky, and sets out to warn the King that "The sky is falling!" Now some traders and investors are acting like Chicken Little, but instead of fretting that the sky is falling, they're sounding the alarm that interest rates are rising.
You don't need to be a Nobel-winning economist to know that interest rates will rise at some point. The Federal Reserve has left short-term interest rates (the Fed funds rate and the discount rate) at 46-year lows for almost a year after sending them on a downward trajectory from their recent high in May 2000, two months after the stock market peaked.
Even naysayers are starting to believe that this current economic recovery is broad based and has legs. With this type of economic momentum, interest rates are bound to rise to stave off the curse of inflation that typically accompanies strong growth. The Fed moves in increments, typically in moves of 25 basis points -- that is, a quarter of a percentage point.
So why is the market acting like the sky is falling? Because many investors who see an end to the gravy train of great profits with little or no effort want to get out of the market before everyone else, possibly creating a greater stampede in the process.
Case in point: April 2. The monthly employment situation report released that day showed a stunning gain of 308,000 new U.S. jobs. The fact that unemployment is a lagging indicator and was due to show some improvement was all but ignored by the cognoscenti who proceeded to set off the worst one day loss in eight years for the 10-year Treasury note.
Chicken Little saw the sky falling -- that is, inflation fears rising -- and convinced all her barnyard friends of it.
Yet the Fed isn't going to hike interest rates by more than a quarter percent unless they see something much uglier than the 0.5 percent increase in consumer prices reported last Wednesday. Fed Chairman Alan Greenspan, in yesterday's testimony before the Senate Banking Committee, said the U.S. financial system is "strong and well-positioned" to meet the challenge of higher interest rates, although he made no comments on monetary policy.
And even if you did see a knee-jerk sell-off reaction in interest rates sensitive stocks such as banks, homebuilder's utilities and real estate investment trusts, the strong economic growth that higher rates reflect are long term positives for those sectors. In fact, separate studies by investment strategists Steve Leuthold and Ned Davis show that stock market trends tend to continue going up after the initial interest rate hike in a series. During the last series of rate increases from November 1998 to May 2000, there was a rolling sector effect, similar to what was seen in the 1992 to 1995 rate hike period. Certain sectors do well as the economy starts to anticipate rising rates, then yield to other sectors as the tightening gets underway, and finally other sectors take over leadership as tightening enters its late stages.
So there's no need to panic just because interest rates are going to rise. As Greenspan noted in June 1998, it's the normal, "virtuous cycle in which rising equity values are providing impetus for spending and, in turn, the expansion of output, employment, and productivity-enhancing capital investment." While you shouldn't jump into new bond positions if you expect rates to rise, hold onto your existing bonds until they mature, and look for opportunities in the equity market as we shift from easy money to higher rates.
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