Tuesday, 3 January 2006

Interest rate movements threaten sanguine outlook for stocks

Stocks around the world generally performed well in 2005, continuing a global bull run in equities that has now lasted around three years. Investors generally seem to expect this run to continue, despite the fact that many central banks around the world are still raising interest rates.

The following table shows the strength of the global bull run in equities in 2005, with most markets showing double digit returns. Japan's Nikkei 225 in particular rose a whopping 40 percent to close the year near five-year highs.

 Start of
End of
S&P 5001,211.921,248.293.0
Nikkei 22511,488.7616,111.4340.2
FTSE 1004,814.35,618.816.7
CAC 403,821.164,715.2323.4
Hang Seng14,230.1414,876.434.5
Straits Times 2,066.142,347.3413.6

On the whole, analysts are sanguine about the prospects for stocks in 2006. A BusinessWeek survey of market forecasters in December showed a consensus forecast for the Standard & Poor's 500 Index of 1,347 for end 2006, 7.9 percent higher than its close at the end of 2005. Similarly, a CNBC survey of 2006 forecasts for the S&P 500 from seven big Wall Street firms showed an average of 1,348.

A rise in the S&P 500 of around 8 percent would represent a relatively good performance, considering widespread expectations for a slowdown in the economy and corporate earnings growth and the fact that the stock market has already been in a bull run for about three years.

And the optimism is not restricted to the US stock market. Despite its strong run in 2005, the Japanese market remains popular among investment managers, with one being quoted recently by Bloomberg as saying: "Japan is by far the most exciting equity market in the world." And despite the good performances of European stock markets in 2005, many fund managers remain overweight in European stocks.

All this optimism in stocks may sound strange when seen against the backdrop of rising interest rates worldwide. The Federal Reserve has been hiking interest rates since the middle of 2004 while the European Central Bank made a tentative start to monetary tightening last month and is expected to hike interest rates further this year. Even the Bank of Japan has been making noises about ending quantitative easing in its deflation-riddled economy. Interest rate increases are supposed to be bad for stocks.

However, one oft-cited reason for a relatively good showing by stocks this year, especially in the United States, is the expectation that the Federal Reserve will soon stop raising interest rates. If interest rate increases are bad for stocks, then an end to interest rate hikes should be good for stocks, or so the reasoning goes.

However, investors thinking this way need to look at the evidence more closely. While it may be true that the Federal Reserve indeed stops raising interest rates some time in 2006, stock market history does not suggest that stocks do well when interest rate hikes stop. Rather, it suggests that stocks do relatively poorly at the end of Federal Reserve tightening and only do well when the Federal Reserve starts cutting interest rates.

John Hussman of the Hussman Funds put things in perspective in a commentary on 19 December. In the commentary, he pointed out that since 1950, following the last hike of each tightening cycle where the Federal Reserve has raised rates at least twice, the S&P 500 has delivered annualised total returns averaging 2.47 percent over the following six months, 5.06 percent over the following year, and 8.55 percent over the following 18 months.

"In other words, the market's return has actually been sub-par for a reasonably long period following the final hike of a rate tightening cycle," he wrote.

Stocks only do well when the Federal Reserve starts cutting interest rates. According to Hussman, following the first cut of a new easing cycle, the S&P 500 has delivered annualised total returns averaging 23.01 percent over the following six months, 21.18 percent over the following year, and 22.12 percent over the following 18 months.

Hussman further points out that in periods in which the stock market is trading at price/peak earnings multiples of 16 or above -- as it is now -- the returns were even poorer. In such periods, total annualised returns following the final rate hike of a tightening cycle averaged -7.18 percent over the following six months, -9.94 percent over the following year, and -5.87 percent over the following 18 months.

Even after the first rate cut, annualised total returns during these periods have only averaged -3.63 percent over the following six months, 5.47 percent over the following year, and 5.52 percent over the following 18 months.

So investors looking to an end in Federal Reserve rate hikes for a boost in stock prices may be in for some disappointment.

The other phenomenon that has recently caused investors some concern is the flattening of the yield curve -- specifically, the spread between 10-year and 2-year Treasuries. On 30 December, 10-year Treasury yields stood at 4.39 percent while 2-year yields stood at 4.40 percent.

Historically, stocks have usually not done well when the spread between the 10-year and 2-year has been negative for a sustained period. This happened in 1980-81, 1989 and 2000, periods which were accompanied or followed by substantial falls in the S&P 500.

While economists generally do not think that the current shape of the yield curve is forecasting a recession, a slowdown at least certainly looks plausible. One question for investors is whether markets are pricing a possible slowdown in the economy. Based on the rather meagre rise in the S&P 500 last year, it is possible that it already has.

However, probably a more important question is whether the yield curve could become significantly inverted and for a sustained period. This can easily happen if the Federal Reserve raises interest rates higher than markets expect, or if the economy proves weaker than many think.

Under such conditions, the current consensus analyst forecasts could prove overly sanguine, and leave stock markets vulnerable to a substantial correction some time this year, a correction that might not be reversed until the Federal Reserve actually starts cutting interest rates.

However, even the prospects for a quick uplift in stock prices once interest rates are cut cannot be taken for granted. During the last bear market starting 2000, the Federal Reserve started cutting interest rates in January 2001. The bear market did not end until 21 months later.

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