You might think rising rates are bad for stocks, but recent history is clear, and counterintuitive, suggests Jim Woods, editor of Successful Investing.

You see, it turns out interest rate hikes are actually good for stock returns (at least until a certain point). My data analysis partners at Sevens Report Research recently reviewed the performance of stocks during the two most-recent rate hike cycles.

The first such cycle occurred from August 2004 (the first rate hike of the cycle) to June 2007 (the first rate cut that ended the rate hike cycle) and the second from December 2015 to August 2018, and both periods saw substantial gains for the major equity indices.

From August 2004-June 2007, the S&P 500 rose 40.64% and all four major equity indices (S&P 500, Dow Industrials, NASDAQ Composite and Russell 2000) saw gains of more than 37%.

Then, from December 2015 to August 2019, the S&P 500 gained 49.55% and all four major equity indices saw gains of more than 30%. My point is that for both rate hiking cycles, the major indices saw broad and substantial gains.

But the relative performance of the major indices, and more specifically the performance of growth vs. value, was substantially different for each cycle.

From ’04-’06, the Russell 2000 outperformed the other major indices, rising 57% while the NASDAQ lagged, rising 39%. And if we think about it, that makes sense. From 2004-2006, the tech sector was still recovering from the trauma of the tech bubble, and many of the so-called FAANG names and other super-cap tech stocks were either in their infancy or weren’t public. Back then, it was strong “real” economic growth that powered the gains in stocks, and that ben- efitted small caps and value over growth stocks.

The ’15-’19 rate rising cycle produced opposite performance. The NASDAQ handily outperformed, rising 68.70% while the Russell 2000 lagged, gaining just 31%. And if we think about it, that makes sense. The advancements in technology were going parabolic during that period, economic growth remained largely unspectacular favoring tech, and financials were still recovering from the trauma of the financial crisis.

So, what these two periods reinforce is what I and other market watchers have always known, which is that the number of rate hikes themselves don’t matter in an absolute sense, they only matter as they impact economic growth.

In the ’04-’06 cycle, the Fed raised rates from 1% to 5.25% in less than two years. Yet despite that aggressive hiking, it still took the Fed nearly 18 months to cause the inversion of the 10s-2s yield spread. The economy was strong enough that it could handle that intense increase in rates for nearly two years, and the equity markets rallied for several months after the yield curve inverted.

In the ’15-’19 cycle, the Fed raised rates from 0.25% to 2.50% over three years. And the 10s-2s spread didn’t invert until eight months after the Fed paused rate hikes, in August of 2019.

So, we need to watch 10s-2s, as it remains the key indicator. Because during the last two rate hike cycles, when the first rate hikes came the 10s-2s spread was 1.80% and 1.35%, respectively.

Right now, the 10s-2s spread is less than 80 basis points, and while I do expect the curve to widen, the bottom line is that we’ll have to watch this metric carefully as the Fed prepares to hike rates. It will tell us a lot about the future of equities.

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