What Do I Invest in If I Think Interest Rates Will Rise?


August 8, 2017

There has never been a shortage of worries when thinking of investing your money:  terrorism, epidemics, politics, economic worries, and countless other potential pitfalls. Worries about what to invest in if you think interest rates will rise is no different. While there is no such thing as a list of investments that are guaranteed to perform well in a rising rate environment, we can give you time-tested advice that has helped our portfolios through four decades of rising rate environments.

There are some good ideas out there, but also plenty of bad ones. We believe that there is a simple and FREE solution that is available to any and all investors. What is it? Patience. It’s the one, consistent thing we think is a terrific risk mitigation tool, especially for investors with a long-term investment time horizon.  Investors with the patience to stick with a diversified portfolio of stocks in times of rising interest rates have historically done well. While there can never be any guarantees, more than nine decades of market history indicate that the longer one holds a stock, the less the chance of losing money.

Value Stocks & Dividend Paying Stocks

The odds of the total return earned by the Value stock and Dividend-paying stock subsets of the overall stock market beating the current 2.35%[1] yield on the 10-Year U.S. Treasury bond increase dramatically over the long term. It shouldn’t be a surprise that Value stock pickers like Value stocks. But there is historical evidence for our optimism.

The Case for Value Investing

We believe that you pre-pay for expectations in growth stocks, whereas value stocks have already been discounted. This is why over the long-term, growth stocks have trailed value stocks, returning an annualized average of 9.4% while value stocks have returned an annualized average of 13.6% over the same time period.

Download The Case for Value Investing

Figures 1 & 2: From 07.31.27 through 05.31.17. Value stocks represented by 50% small value and 50% large value returns rebalanced monthly. Dividend payers represented by 30% top of dividend payers, 40% of middle dividend payers, and 30% bottom of dividend payers rebalanced monthly. SOURCE: Al Frank using data from Professors Eugene F. Fama and Kenneth R. French.

Value Stocks from 1927-2017

Figure 1: Value Stocks from 1927-2017

Dividend Paying Stocks from 1927-2017

Figure 2: Dividend Paying Stocks from 1927-2017

The Latest from the Federal Reserve

We might have expected a bit more in the way of fireworks, given that the Federal Reserve made a series of announcements in conjunction with the June Federal Open Market Committee meeting on June 14, 2017. Fed Chair Janet Yellen said, “Today, the Federal Open Market Committee decided to raise the target range for the federal funds rate by 1/4 percentage point, bringing it to 1 to 1-1/4 percent. Our decision to make another gradual reduction in the amount of policy accommodation reflects the progress the economy has made, and is expected to make, toward maximum employment and price stability objectives assigned to us by law.”

Of course, the FOMC Statement continued to include the reminder, “The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.”

Using data from Bloomberg, the Fed Funds Futures market indicated that the latest interest rate increase is likely to be the last this year, as the odds of another hike happening presently do not make it to 50% until the December 2017 FOMC meeting. Even by the first meeting in January 2019, the odds for an interest rate above 2% are less than one in twenty.

Investing in a Rising Rate Environment

While many market pundits are busy warning of the risk of higher interest rates, we think the absolute value of the Fed Funds rate is far more important than the direction of the change. Market history suggests that those who like Value Stocks should not be concerned that the Fed has initiated a rate tightening cycle.

Prior to the current cycle, data from historical fed funds rate increases from 1954 – 2004 offers perspective as to what we might expect. Value stocks outperformed both the S&P 500 and Growth stocks after a Fed Liftoff. For example, five years after Liftoff, Value stocks returned average of 14.6% per annum, compared to Growth stocks’ return of 7.9% and the S&P 500 index’s return of 9.6%. This is also the case for those who prefer Dividend Payers, which returned an average of 10.4% per annum, compared to Non-Dividend Payers return of 6.9%. For those interested in the nearer term, similar patterns of Value and Dividend Payer outperformance hold for two and three years after Liftoff[2].

Next time you ask yourself what to invest in if you think interest rates will rise, we find again that Value stocks, particularly dividend-paying Value stocks, would seem to be a good place to start.

Staying the Course

Our thoughts on this subject haven’t changed much since early 2015 when we said, “It is hard to be unhappy, in our view, about more folks finding jobs, especially as the consumer is so important, even as we realize that a healthier economy will eventually force the Federal Reserve to cease being patient in beginning to normalize the stance of monetary policy. Of course, while we know that stocks threw a Taper Tantrum back in May/June 2013 when then-Chairman Ben Bernanke suggested that the Fed would eventual reduce its Quantitative Easing program, a near-zero interest-rate policy is far from normal, especially considering the average level of the Federal Funds rate going back to 1971.”

Although interest rates have risen at a pedestrian pace so far, we believe that the Fed will continue to hike rates as the macroeconomic backdrop improves. And investors seem to like the interest rate path. The broad-market S&P 500 index has risen more than 20%[3] including dividends since the Fed first started raising rates in December 2015. We often see the press making bold proclamations about the direction of the market, with opinions that swing wildly—almost hourly—between headlines like “the Stock Market is Going Up in Flames” and “Market will Go Screaming Higher.” Certainly, the exasperated headlines do well to sell newspapers or gain viewers, but they don’t make for good investing advice.

Rather than pretending to have a market crystal ball that can predict the next few minutes with certainty, we feel much more comfortable investing our diversified portfolios of dividend-paying, undervalued stocks. This offers long-term appreciation potential through thick and thin, taking the good days, weeks, months and years along with the bad, secure in the belief that in the fullness of time patience eventually will be recognized and rewarded. This philosophy can be applied to investing if interest rates rise, as well as any other season.

The Case for Value Investing

We believe that you pre-pay for expectations in growth stocks, whereas value stocks have already been discounted. This is why over the long-term, growth stocks have trailed value stocks, returning an annualized average of 9.4% while value stocks have returned an annualized average of 13.6% over the same time period.

Download The Case for Value Investing

[1] July 27, 2017. http://www.marketwatch.com/investing/bond/tmubmusd10y?countrycode=bx. Not intended to be representative of historical yield 1997-2017.

[2] Data from Bloomberg, Professors Eugene F. Fama and Kenneth R. French, St. Louis Fed, Deutsche Bank and Morningstar. Data from December 1954 through June 2004.

[3] As of July 14, 2017

Nothing presented herein is, or is intended to constitute, investment advice, nor sales material, and no investment decision should be made based on any information provided herein. The information provided herein is educational in nature, is not individualized, and is not intended to serve as the primary basis for your retirement, investment, or tax-planning decisions.

No guarantee of investment performance or dividend payment is being provided and no inference to the contrary should be made.

Value stocks are shares of a company with solid fundamentals that are priced below those of its peers, based on analysis of price/earnings ratio, yield, and other factors. Please note that the illustrated depictions are not intended to be representative of any individual product available through AFAM Capital, Inc.

The performance of growth stocks as illustrated is comprised of 50% small growth stock returns and 50% large growth stock returns. The performance of value stocks as illustrated is comprised of 50% small value stock returns and 50% large value stock returns. The performance of dividend paying stocks as illustrated in Figure 3 is comprised of the returns of the 30% highest dividend payers, 40% mid-range dividend payers, and 30% lowest dividend payers – calculated using dividend yield. The performance of non-dividend paying stocks as illustrated in Figure 3 is comprised of the returns of stocks that do not pay a dividend. All as of dates indicated, rebalanced monthly, and derived using data from Professors Eugene F. Fama and Kenneth R. French. http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

The S&P 500 Index is a broad market sample based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ.

Investing involves risk, principal loss is possible, and there can be no assurance that investment objectives will be achieved. The information presented herein is for discussion and illustrative purposes only and does not constitute investment advice. It is not a recommendation or an offer or solicitation to buy or sell any securities.

Information provided reflects AFAM’s views as of a particular time. Such views are subject to change at any point and AFAM shall not be obligated to provide notice of any change. While AFAM has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability or completeness of third party information presented herein.

244-AFAM-8/2/2017

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