Stock Picking May Not Be Best Solution During Tightening Periods

The Bengals took the field on Feb. 13 for their first Super Bowl appearance in over 30 years. Do you know what else has not happened in more than 30 years? Consumer Price Index numbers being this high.

With the latest inflation statistics, talks regarding rate hikes and quantitative tapering have become the new norm as banks forecast different scenarios. Although inflation has not risen to this level in over three decades, it is not the first time that the Federal Reserve (Fed) has relied on rate hikes, among other tools, to tame it.

Inflation refers to the increase in general prices and decrease in the purchasing power of money. Higher inflation would mean that the cash we keep in our wallets is losing its value. The level of inflation is determined by weighing different goods within a “typical” basket (housing, medical care, apparel, etc.) and measuring the change in prices.

While the future is uncertain, we can look at historical periods of high inflation to inform our expectations amid the current circumstances.    

Between 2004 and 2006, the Fed opted for 17 consecutive hikes, bringing the federal funds rate to 5.25%, as seen in this week’s chart. From May 31, 2004, to Aug. 31, 2007, the S&P 500 Index had a total return increase of 31.53%. Housing prices peaked around the middle of 2007, and rates were cut to zero soon after the 2008 financial crisis started.

During this period, several sectors performed differently from one another:

Throughout this period of tightening policy, it is notable that the overall market did not incur major losses compared to individual firms. However, sectors such as energy, utilities, materials and industrials outperformed the S&P 500 Index during this time while health care and consumer staples underperformed.

Meanwhile, in comparing value vs. growth stocks, the former outperformed the latter by 15.92% in total return when using iShares Core S&P U.S. Value ETF (41.47%) and iShares Core S&P U.S. Growth ETF (25.55%).    

In 2015, the Fed again implemented rate hikes; this time bringing rates to 2.5% before cutting them on June 28, 2019. From Dec. 31, 2015, to June 28, 2019, the S&P 500 Index had a total return of 43.93%.

The same sectors performed as follows:

Throughout this period of tightening policy, growth outperformed the S&P 500 Index and value stocks, as iShares Core S&P U.S. Growth ETF saw a total return of 54.42% compared to 33.41% for iShares Core S&P U.S. Value ETF.

During the two tightening periods described above, the Fed raised rates more than the market anticipated. Currently, the market is pricing a total rate increase of 159 basis points separated across seven hikes for this year alone. Based on the previous scenarios I’ve detailed, the market should not be surprised if the Fed chooses to increase rates even more.

It is worth mentioning that among commodities, oil prices increased in tandem with each hike period. Barrel prices rose 92.26% during the first tightening period described above and up to 255.02% in the months following, then increased 62% during the second tightening period.

Key Takeaway

The market is typically not as adversely affected during tightening periods as it is in the period that follows. Some sectors are more affected than others; therefore, stock picking might not be the best solution. Instead, focusing on a sector investing strategy could prove to be more beneficial.

Chart Definitions

Federal Funds Rate (FDTR): The federal funds rate (fed funds) is the short-term interest rate target set by the Federal Reserve's Federal Open Market Committee (FOMC) as part of its monetary policy. In December 2008, the target "fed funds" level was replaced by a target range, and this ticker (FDTR) represents the upper bound of that range.

S&P 500 Index: A market-capitalization-weighted index of 500 leading publicly traded companies in the U.S. 

Industrial Select Sector SPDR Fund (XLI): An exchange-traded fund incorporated in the U.S. XLI seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the Industrial Select Sector Index (Index). The Index seeks to provide an effective representation of the industrial sector of the S&P 500 Index. 

Utilities Select Sector SPDR Fund (XLU): An exchange-traded fund incorporated in the U.S. XLU seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the Utilities Select Sector Index (Index). The Index seeks to provide an effective representation of the utilities sector of the S&P 500 Index.

Sector ETF Definitions

Energy Select Sector SPDR Fund (XLE): An exchange-traded fund incorporated in the U.S. The ETF seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the Energy Select Sector Index (Index). The Index seeks to provide an effective representation of the energy sector of the S&P 500 Index. 

Materials Select Sector SPDR Fund (XLB): An exchange-traded fund incorporated in the U.S. The ETF seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the Materials Select Sector Index (Index). The Index seeks to provide an effective representation of the materials sector of the S&P 500 Index. 

Technology Select Sector SPDR Fund (XLK): An exchange-traded fund incorporated in the U.S. The ETF seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the Technology Select Sector Index (Index).  The Index seeks to provide an effective representation of the technology sector of the S&P 500 Index. 

Financial Select Sector SPDR Fund (XLF): An exchange-traded fund incorporated in the U.S. It seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the Financial Select Sector Index (Index). The Index seeks to provide an effective representation of the financial sector of the S&P 500 Index.          

Consumer Discretionary Select Sector SPDR Fund (XLY): An exchange-traded fund incorporated in the U.S. The ETF seeks to provide investment results that, before expenses, correspond generally to the price and yield performance the Consumer Discretionary Select Sector Index (Index). The Index seeks to provide an effective representation of the consumer discretionary sector of the S&P 500 Index. 

Consumer Staples Select Sector SPDR Fund (XLP): An exchange-traded fund incorporated in the U.S. The ETF seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the Consumer Staples Select Sector Index (Index). The Index seeks to provide an effective representation of the consumer staples sector of the S&P 500 Index. 

Health Care Select Sector SPDR Fund (XLV): An exchange-traded fund incorporated in the U.S. The ETF seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the Health Care Select Sector Index (Index). The Index seeks to provide an effective representation of the health care sector of the S&P 500 Index. 

Tags: Fed tightening | Federal Reserve | rate hikes | CPI | Inflation

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