A Fed rate hike is coming, — if not this month then certainly the next.
Some investors will have convinced themselves that the big stock market correction is upon us — that this time is the right time to sell.
Yet when crunching fundamentals and scrutinizing similar situations, the opposite seems to ring true. The rally is set to continue for a while, and the latest correction in the stock market? Well that just might be the setup for a classic “buy-on-the-dips” scenario.
Here’s why:
Stock Markets Rally After Rates Rise
It’s true that when the Fed tightens monetary policy and raises rates, eventually the stock market turns bearish.
The big emphasis there should be on the “eventually” part. Historically, “eventually” comes not upon the first rate hike, but towards the end of a tightening cycle.
In point of fact, often times when a bear stock market begins, rates have already begun to fall. Eventually, the decline does come, but usually long after the first rate hike. It’s not unusual for the decline to take as long as a year or two after.
Take, for example, the last two major stock corrections, i.e. the dot.com debacle and the most recent mortgage crisis. When the bear market of 2008 began, the Fed had already cut interest rates by more than 1%. When the stock market had finally topped out, interest rates were above 5%.
And the dot.com burst? The Fed has raised rates more than five times before the bear market actually began. So why would we expect it to be different this time?
And let’s not forget the rather moderate growth of this business cycle. That suggests that rate hikes might move slower than before. That means this market’s peak is still quite some distance away.
SPY Fundamentals Support a Bull Market
There’s another case for the stock market (i.e. the S&P 500) rally to continue even after the first rate hike. That case becomes apparent when we examine the SPDR S&P 500 ETF (SPY).
One classic methodology to gauge whether a stock index is overvalued is to compare the earnings yields to risk-free rates. In other words, you compare the index to U.S. Treasuries.
The earnings yield is, quite simply, the reverse of P/E; that is, earnings divided by price. Currently, the S&P 500 P/E ratio, according to SPY ETF fact sheet, is 18.85. Its reverse means an earnings yield of 5.3%. Meanwhile, the U.S. 10-year Treasury yield is at 2.23%, or roughly half the earnings yield. This suggests that, at least when it comes to evaluating the SPY ETF, there’s more time to run before turning bubbly.
How to Play This Stock Market?
If evidence strongly suggests a longer stock market run, then buying the SPY ETF at each dip could be a good strategy to maximize returns.
If you prefer to act a bit more prudently, perhaps it’s time to turn to the good old dollar-averaging strategy — that is, to buy the SPY in a fixed dollar amount each month or quarter. That way, when the stock market retreats you are buying more and, of course, vice versa.
A dollar-averaging strategy is generally preferred when an investor wants to buy into the stock market for the longer term. That said, there are, of course, no guarantees when it comes to the stock market. If there were, we’d all be millionaires.
But before you press the sell button in your haste to flee the market before a rate hike, stop for a minute. Think hard.
Ponder whether or not the evidence really does suggest that it’s time to hit the escape button.
As of this writing, Lior Alkalay did not hold a position in any of the aforementioned securities.
