After a decade-long period of unusually low interest rates, a heated up economy and full labor situation are forcing the Fed to once again tighten monetary policy. The result? The era of low interest rates is over. We are now heading back to era of normal interest rates. But there are still stocks to buy as interest rates rise.
The interest rate rise caused shocks throughout the stock market. After all, this has been a growth-led market. Growth stocks tend to do well in low interest rate environments because down-the-road profits have a higher present value. But, as interest rates rise, those down-the-road profits have lower present values. Thus, growth stocks tend to struggle as interest rates rise.
Not surprisingly, as the 10-Year Treasury Yield broke out to multi-year highs of right around 3.2% on October 4, stocks dropped. Specifically, the growth-centric Nasdaq dropped nearly 2%.
Importantly, this seems like much more than just a head fake on the 10-year. The 10-year broke out earlier this year, but failed to break above 3% and yields have been largely stuck in neutral ever since. Now, though, yields are breaking out again. This rally seems like the big one. Not only is the economy heating up, but unemployment is low, inflation is starting to pick up, wage growth is coming into the picture, and the Fed is sounding more hawkish than ever.
The big takeaway? Rates are going higher for the foreseeable future.
That changes the investment game. You may want to start buffing up your portfolio with names that tend to outperform when rates go up. What types of stocks fit that description?
Let’s take a deeper look at the types of stocks to buy as interest rates rise.
Types of Stocks to Buy As Interest Rates Rise: Bank Stocks
The most obvious group of stocks to buy as interest rates rise are bank stocks. This includes names like JPMorgan Chase (NYSE:JPM), Bank of America (NYSE:BAC), Citigroup (NYSE:C), and Wells Fargo (NYSE:WFC).
Why buy bank stocks? Because banks make more money as interest rates go up. It’s that simple. When interest rates go up, that’s usually a result of the economy heating up — which is exactly what we have right now. When the economy is heating up, consumers tend to spend more and be more financially active, which is also exactly what we have right now. And, when that happens, banks do more business and make more money.
Also, banks make a ton of money from something called net-interest income, which is essentially the profits generated from interest-bearing assets. When interest rates go up, those interest-bearing assets produce more money. Thus, when interest rates go up, banks generate more profit through net-interest income. This isn’t a small line item. For example, JPM reported net interest income of $13.6 billion last quarter.
Overall, bank stocks are simply a good place to park your money as rates rise. To be sure, on October 4 while the market plunged, all four major bank stocks (JPM, BAC, C, and WFC) closed higher, as did the Financial Select Sector SPDR ETF (NYSEARCA:XLF). This trend of bank stock out-performance should persist so long as rates go higher and pressure broader equity valuations.
Types of Stocks to Buy As Interest Rates Rise: High Dividend Stocks
Another group of obvious stocks to buy in a higher interest rate environment are stocks with high dividend yields. Why? Because as interest rates go up and pressure equity valuations, investors seek risk-protection. Stocks with big dividend yields provide big risk-protection, and thus, investor demand for big dividend stocks rises as interest rates rise.
The flip-side of this is that as interest rates rise, that also pressures equity dividend yields because now the risk-free rate is moving up. Thus, when picking big dividend stocks for a higher interest rate environment, you want to pick stocks with dividend yields that will remain considerably higher than the 10-Year Treasury yield.
The 10-Year Treasury yield is currently at 3.2%. Over the next several months, given a strong economy, accelerating inflation, and a hawkish Fed, you could see that yield head up to 3.5%. So, the big dividend stocks to buy here and now to mitigate interest rate risk are stocks with yields above 3.5%.
Who fits that description? AT&T (NYSE:T) is the first name that comes to mind, with a 5.8% dividend yield. Verizon (NYSE:VZ) is another obvious choice, with a 4.3% yield. BP (NYSE:BP) and Exxon Mobil (NYSE:XOM) both look good for oil upside and with yields at 5.2% and 3.7%, respectively. There’s also utility giants American Electric Power (NYSE:AEP) and Duke Energy (NYSE:DUK) with yields at 3.6% and 4.5%, respectively.
Overall, if you want some stocks to buy as interest rates rise, you should consider adding some high yield names to your portfolio. My top picks include T, BP, and AEP, mostly for their stability and attractive yields.
Types of Stocks to Buy As Interest Rates Rise: Low-Multiple Stocks
The last obvious group of stocks to buy as rates rise are low-multiple stocks. As interest rates rise, the fixed income yield rises and closes in on the equity earnings yield. The spread between these two yields is often referred to as the equity risk premium. As this risk premium narrows, investors are being compensated less for taking on additional risk in stocks. As such, as the risk premium goes down, stocks look less attractive relative to bonds. The result is a shifting of funds from stocks to bonds.
Low-multiple stocks have higher earnings yields. Thus, they have a larger risk premium. This larger risk premium essentially means low multiple stocks have more cushion to resist against higher rates.
The current 10-Year Treasury Yield is at 3.2%. The current forward earnings yield for the S&P 500 is about 5.9%. Thus, the equity risk premium is 2.7%. That is still fairly good, so stocks can continue to perform even if rates go higher. But, stocks with bigger risk premiums should perform better.
Which stocks fit this description? Intel (NASDAQ:INTC) comes to mind first, because this is a true growth company trading at just 11.6x forward earnings. Retail heavyweights like Target (NYSE:TGT), Macy’s (NYSE:M), and Kohl’s (NYSE:KSS) also all look good because they are trading at below-average multiples, but should likewise benefit from a boost in consumer spending. There’s also industrial giants like Caterpillar (NYSE:CAT) and Deere (NYSE:DE), two stocks with sub-16 forward multiples and healthy exposure to economic expansion.
Overall, low multiple stocks have more cushion to protect against rising rates, and as such, buying a few low-multiple names could be a good way to de-risk your portfolio. There are a handful of good low multiple names out there. But, I really like INTC here and now, and also think retail and industrial stocks will outperform for the foreseeable future.
As of this writing, Luke Lango was long JPM, XLF, T, BP, XOM, AEP, INTC, and M.