According to some theories, stock prices take into account everything that’s known about a company’s prospects. You can’t beat the market, because so many smart people have already discounted everything that can be known about corporate earnings, the economy, and interest rates. The stock market is a lean, mean, discounting machine.
Close to midday on August 7, 2015, the Dow Jones industrial average is down about 121 points, or 0.70%, on news that the monthly employment report for July was pretty good, increasing the odds that the Federal Reserve would increase interest rates at its September meeting.
What is remarkable is that anyone should be surprised that interest rates are going to rise. The fed funds rate is currently zero. There is no other direction short-term interest rates could go. Not factoring in higher short-term rates is like betting your flight to Chicago will get there via the Ohio Turnpike.
The only question is when, and even that is not that interesting a question. It will most likely be in September or December. The Fed has done practically everything but rent an airplane banner over the Jersey shore saying a rate hike is coming soon. “I think there is a high bar right now to not acting, speaking for myself,” Atlanta Fed president Dennis Lockhart said Tuesday, the latest in a salvo of Fed warnings.
If the stock market has not discounted the possibility of higher rates by now, it may not be the fearsomely efficient market it’s made out to be in some quarters. One possibility — which I think is true — is that the stock market is a mirror of howling human emotions, and that somewhere in the back of our cortex, like the fear of snakes and thunderstorms, is the fear of higher interest rates and a slower economy.
And history bears this out. Usually, the first interest rate hike is met with a stock selloff, followed by a rally, as investors realize that higher rates are usually a sign that the economy is doing well. It’s not until well into a rate-hike cycle that higher rates slows the economy meaningfully.
Long ago — ok, the 1980s — traders pointed to the “three steps and a stumble” rule. When the Fed had raised interest rates three times, the rule went, stocks would fall. The third hike was an indication that that Fed wasn’t simply following market rates, but intended to slow the economy.
But in those days, the Fed typically started from a more or less normal short-term interest rate of 4% or so. Assuming the Fed raises interest rates in quarter-point increments — which is what has done for the past 20 years or so — it would take sixteen steps to get to a normal 4% fed funds rate. The stumble could be a long time coming.
In any event, anyone who is surprised by a Fed rate hike this year shouldn’t be. And anyone who thinks that a 0.25% fed funds rate will slow the economy or kill the stock market should worry about other things. Really, the biggest worry here is not that stocks are selling off in reaction to a rate hike that has been in the works for nearly half a decade. The biggest worry is that stocks are selling off because the market senses a softer economy and softer earnings in the future, and that the Fed is raising rates too soon. But it’s more likely that that the market is simply doing what it usually does — overreacting to the start of a Fed tightening cycle.