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Will the Fed's steps lead to a stumble?

A long-held stock market selling rule may not apply this time around

Dec 13, 2016 @ 11:52 am

By John Waggoner

Unless everyone in the universe is wrong — which has been known to happen — the Federal Reserve will nudge up short-term interest rates by a quarter of a percentage point Wednesday. Is it time to worry that rising rates will hurt the stock market?

The most famous saying about rising interest rates is by legendary market technician Edson Gould, who formulated the “three steps and a stumble” rule. Basically, the rule says that the stock market tends to fall after the Federal Reserve has raised the fed funds rate three times.

The logic behind the rule is fairly simple: The market sees the Fed's first few rate hikes as confirmation that the economy is growing. By the third hike, however, yields from bonds and cash become more competitive with stock returns, and market participants start to suspect that the Fed wants to slow the economy to ward off inflation.

The current low level of interest rates throws some doubt on how effective the rule will be on the third round of this cycle (Wednesday's will be the second round).

“Historically, fed funds trade a percentage point and a half above inflation,” said Sam Stovall, chief investment strategist for CFRA. The Consumer Price Index has gained 1.6% the 12 months ended October, which would mean a normal fed funds rate would be 3.1%.

Given that the fed funds rate is currently 0.25% to 0.50%, and that the Fed tends to move rates in quarter-point increments, it could be many more steps before a stumble.

And, while the stock market tends to overreact to any Fed news — it tumbled after the first rate hike in seven years — Stovall doesn't think stocks will get clobbered by a quarter-point rate hike.

For one thing, the Standard & Poor's dividend yield is just a hair below the yield on the 10-year Treasury note. Traditionally, when the S&P yield is within a percentage point of the 10-year T-note, stocks fare well, Mr. Stovall said. And with the scent of 2017 tax cuts in the air, few investors will want to sell before the end of the year.

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