The Lazy, Hazy, Crazy Days Of Summer
The stock market beat goes on. Rumors of Greece defaulting on government debt scare investors and stocks then dip. Rumors that its debt problem will somehow be restructured send the market back up. After a couple of these zigzags, stocks maintain their uptrend, indicating that institutional buying outweighs selling.
Encouraging reports of U.S. employment initially sent stocks down and investors flinched as good economic news heightens the probability of the Federal Reserve finally raising interest rates in September. The market then rallied as investors reflected that good economic news is generally good for corporate earnings and stock prices.
Rather than guessing when the Fed will raise interest rates for the first time since June 2006, investors should give some thought to what stocks do when the Fed actually begins to raise rates. A new article in Barron’s by a strategist with the Nuveen funds reviews these transitions.
There were six rate hikes over the last thirty years. Each came after a period of economic growth, three in the 1980’s, two in the 1990’s and the sixth in June 2004. Unsurprisingly, stocks were moving up prior to each of the rate increases with the average gain 14% from the level a year before the Fed action. Stocks then struggled for a bit with their performance dipping to a 2.6% gain for the year after the first increase.
After another year, stocks weathered the storm and had risen back to the same 14% average gain two years after the rate increase. These gains came despite economic weaknesses, inflation fears, earnings disappointments, wild oil price swings, a surging dollar, geopolitical shocks and continuing valuation worries.
Today’s economic cycle is somewhat typical. The business environment is improving with signs of improving future growth. While economic growth has been slower than in typical recoveries but its pace is steady. Despite the claims of political candidates, inflation in the U.S. has been almost nonexistent for years. After six years of stagnation, employment reports are finally showing early signs of wage gains. As these develop, consumer spending will rise. The oil price collapse held down some prices and the inevitable recovery will add to both growth and inflation.
The big difference in interest rates now is the very low starting point. The fed funds rate is virtually zero now and four or five 25 basis point (.25%) rate increases later this year and next would take the rate to only 1.0% to 1.25%. The average starting point during the six previous rate hike cycles was an average of 5%!
The 10-year Treasury bond currently yields around 2.25%. In the previous cycles, the 10-year yield ranges from 4.6% to as high as 10.3% [!] with an average starting point of 7.0%. The Fed’s more recent patient policies rescued our economy from a deep recession and left it room to grow.
This is a favorable environment for stocks. Growth stocks, with stable earnings will continue to lead. Bond prices will suffer, as will most utilities, whose valuations seem to have been bid up in a dubious search for apparent safety. Rising earnings of healthcare, selected industrial and technology stocks will keep them at the front of the pack.
Two new buys come with excellent earnings growth. Acuity Brands (AYI-$164) is the leading developer of newer LED lighting products. Historic and projected growth are both over 30% even though the company has barely tapped the residential sector.
Mentor Graphics (MENT-$26) is an established innovator of design software. Earnings for its current year will be around $1.88, up from $1.77, providing a reasonable valuation and a good stable mate for higher growth stocks like Acuity.
Those who followed the old cliché to “sell in May and go away” may develop regrets. Those who emphasize quality growth stocks can enjoy “the lazy, hazy, crazy days of summer.”
Tony Crowell manages stock portfolios for individuals and their trust and retirement accounts with CROWELL•ROBERTS Investment Counsel, a registered investment advisor in Laguna Beach since 1995. [email protected] 949.494.1376/800.697.2622