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Tickers in this Article: wfc, hme, idu, nly, exc
The market had a sharp rally yesterday on the tail of the Fed's much expected announcement to raise the Fed Funds rate 25 basis points to 5.25%. The market seemed to bask in the Fed's statement, which was interpreted as not being overly hawkish.

Many on Wall Street had been expecting another 25 basis point increase at the next Fed meeting. The market rally seems to signal that may not be the case. But before you jump in with both feet into the markets, carefully consider the following history of rate increases.

The Fed, despite having the aura of being clairvoyant, works on government data that is prone to errors and significant revisions. For example, take the recent housing release. Housing sales came in stronger than expected in May, rising 6.5%. However, what went largely unreported is that this number had a margin of error of 11.5%.

The Fed's release yesterday issued a guarded statement on the prospect of future rate hikes. The announcement, which was interpreted that the Fed was signaling an end to hikes, was little more than the Fed stating it was taking a "wait and see" attitude.

The Fed is now operating in an environment which is very data dependent on a monthly basis.

What does this mean for investors? Historically, the S&P 500 has declined 5% during the six months after an initial rate hike, and also ended up down 6% after 12 months. Subsequent rate hikes have historically served to further damage equity prices. Looking at the past, the market has not been a very good indicator of future rate changes.

Additionally, interest rates have an inverse relationship with Price/Earnings (P/E) ratios. That is, as interest rates go up, P/E ratios go down. We have now begun to see a decrease in earnings estimates for the second half of 2006 and for 2007. So, as the E in P/E stays even or rises slightly, that means the P must fall to compensate for the fact that the P/E ratio will decline as interest rates rise.

Of course, in 1980 and 1999 the markets rose in the face of rising interest rates, contrary to the historical norm. But, as a matter of history, those abnormalities did not end well for stock investors.

Since year-end, the Fed Funds rate has risen from 4.25% to 5.25%, while the 10-year U.S. Treasury has gone from 4.39% to 5.22%. A deeper look at the impact of these rate hikes suggests that consumers will soon be impacted as well. It has been reported that approximately $30 billion in adjustable rate mortgages and home equity lines that are scheduled to reset will be priced at rates 1.5-2.5% higher. Additionally, credit card rates will increase as well. None of this will be good news for consumer discretionary stocks (autos, retailers, etc).

Conversely, if the Fed is done increasing rates, it will be positive for several sectors of the market; primarily utilities, financials and REITs. Under this scenario, investors might do well investing in stocks like Wells Fargo (WFC), the number two mortgage lender with a 3.40% yield. A REIT that may do well under a stable interest environment might be Home Properties Inc (HME), an apartment REIT with a 4.90% yield.


Apartment rentals may strengthen as home sales cool from the recent rate rise. In the utility sector, investors might look to investing in the Dow Jones Utility Exchange Traded Fund (IDU), which would offer both geographic and fuel-source diversification. In addition to the prospect of higher stocks prices, these stocks typically pay 3-4% in dividend yields. These yields will also provide some downside price protection to investors, since the S&P 500 is currently only yielding about 1.9%.

Conversely, if rates continue to go up, investors might want to avoid stocks like Annaly Mortgage Management (NLY) and Exelon (EXC). NLY is a mortgage REIT that may come under pressure as rates rise in the mortgage sector. EXC, a utility, has a low 2.30% yield and a stock price that has virtually gone straight up since 2003. Rising rates and narrowing margins may lead to increasing numbers of sellers for this stock

Overall, the key will be to mind the Fed. Those who choose to ignore them, do so at their own peril.

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