Moving Past the Interest Rate Speculation

Now that the market had time to process the minutes released last week from the Fed’s December meeting, we can finally move on from the continual speculation about interest rate rises.

Despite the individual views of each Fed official prior to that meeting, one thing did change dramatically… Bloomberg reported that those officials now for the first time unanimously (and belatedly) expect rates to begin rising this year.

And all bets are now on the first rate rise to take place in March.

Perhaps the only development in the past few days has been the reaction by some of the bigger players in the market.

Goldman Sachs now believes that the Fed will increase rates four times this year (up from three). JPMorgan Chase CEO Jamie Dimon even went one step further, saying he’d be surprised if it was only four.

It all sets us up for one intriguing (and potentially lucrative) year…

While the timing and number of rate rises will continue to attract headlines, there’s only one outtake that matters… After nearly two years of zero interest rates, the faucet is firmly and systematically about to turn off.

And that has major ramifications for stocks.

In 2021, investors who simply held the broader market enjoyed some stellar returns. The S&P 500 finished the year up 27%, with the Nasdaq up just over 21%. That marked the third straight year of gains for both indexes.

However, investors are going to run into two clear challenges in 2022…

First, shutting off over-accommodative monetary policy will see money coming out of the markets… and that could cause (and exacerbate) any falls. And second, when interest rates start to rise, not all stocks will be treated the same way.

Those that think they can just blindly hold the broader market and enjoy another year of multi-digit returns will likely be licking their wounds at the end of the year.

That’s why stock (and sector) picking will become key. We’ve already seen that play out during the start of this year…

Rising interest rates benefit banks because it improves the margin between what the bank borrows (interest paid) and lends at (interest received). That’s why JP Morgan Chase, Bank of America, and Wells Fargo got off to a flying start in 2022… the latter is up 15% in just a couple of weeks.

However, on the other side of the equation are the bulk home builders. Even after recovering somewhat in the last couple of days, major builders like D.R. Horton and Lennar are both down around 7-8% over the same time.

This comparison alone highlights how careful investors will need to be in choosing what stocks they’re going to own.

However, the even bigger by-product of rising rates comes back to their impact on high-growth tech stocks. It’s the very segment that drove the market higher since last April.

As we discussed several times last year, rising rates discount the value of future cash flows. Because revenue from high-growth stocks are firmly weighted out into the future, rising rates leaves them more exposed to downside valuations than a regular industrial-style stock.

And unless they issue new (usually discounted) stock, those same companies (often running at a loss) will also have to pay more through higher rates to fund their business.

Put these two factors together and it’s clear that the market is going to face some hurdles. These factors will determine what the broader market will do this year.

That’s why I’m going to keep reiterating that you’ve got to be very specific in what you own. You’ve got to know exactly why you own everything.

Investors who fail to see that the dynamics have changed – leaving themselves vulnerable to broad downside valuations – run a great risk of tearing a hole in their savings.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict

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