Three Steps And Rumble
For the first time since November, the financial news was not dominated by national politics. The Federal Reserve took center stage, although not dramatically, as it raised interest rates exactly as the financial media had predicted. In its forecast, the Fed indicated that this would be the first of three one quarter-point rate increases during 2017 to be followed by another three quarter-point raises in 2018.
Wall Street had worried that the Fed might step up the pace with a fourth increase this year or that it would step up its forecasts for inflation, which it kept at 1.9% at the end of 2017 and 2.0% in 2018 and 2019. Chairwoman Yellen did leave open the possibility that the Fed would modify its policy if the Administration and Congress could manage to pass big fiscal stimulus spending programs. She also noted that the Fed would not react until any concrete proposals were evident.
The Fed’s action was implicitly bolstered by the surge in stock prices that have pushed the Dow to the 20,000-21,000 bracket. The jobless rate is 4.9%, slightly below the Fed’s “full employment” and inflation is below its current 2% target. All this supports its course change from the emergency record low rates that it instituted in the wake of the 2007-08 financial crises to a new range of upward bumps.
Were rates not still so low, this would be immediately worrisome, as higher rates tend to erode stock prices. The first ripple comes as financial institutions begin increases on credit cards and mortgages. This decreases consumer spending power, ultimately affecting businesses’ sales and profits. Businesses also borrow money and more expensive loans pressure expansion plans and new ventures. Viewing a company’s value through taking the sum of its future cash flows (or earnings) and discounting to the present value yields lower valuations as rates rise.
These effects have spawned another Wall Street saying, “Three steps and stumble,” a rule of thumb warning that three increases by the Fed without an intervening market dip, foretells a stock market setback. This cycle, however, is starting from record low levels and, most critically, within a benign inflation environment. The newest rate hike took the federal funds rate to a 0.75%-1%-range, still comfortably below the inflation rate of 2%. The “real” (inflation-adjusted) rate is lower, thus present conditions prompt “Three steps and rumble.”
Moreover, some sectors initially benefit from rising rates. Banks, insurance companies and other financial institutions often see rising earnings as their lending rates rise. That points to further gains for JP Morgan Chase (JPM-$91), Morgan Stanley (MS-$46), Primerica (PRI-$83) and Visa (V-$90). I prefer these but Bank of America (BAC-$25) should also prosper.
Housing starts last month hit their highest level since 2007 as the economy continues to improve and buyers are hustling ahead of higher mortgage rates. That’s good news for Essent (ESNT-$36), which sells home mortgage insurance. It trades now at only 12 times 2017 earnings.
Global accelerating economic growth is driving new buy recommendation, Intercontinental Exchange (ICE-$61). It owns and operates globally 23 exchanges and clearing houses of which the most famous is the New York Stock Exchange. (ICE is based in Atlanta, Georgia, reflecting the South’s growing financial clout as Bank of America ((with Merrill Lynch)) is based in Charlotte, North Carolina.)
ICE just completed its eleventh consecutive year of record revenues and earnings. These gains have been unusually consistent and it expects $2.90-$3.00 earnings for 2017, up 8%-10%. Dividend yield is 1.3% with increases for the past three years.
Stock strategies are unchanged. Stocks in large, growing companies should form the core, if not all, of most investor holdings with moderate reserves in short-term bond ETF’s or closed-end funds. Vanguard Short-Term Bond ETF (BSV-$79) is a conservative reserve position with a 1.5% yield.
The Federal Reserve could have sent a stiff headwind. It didn’t and investors can stay on course.
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
