S&P and Rate Hikes: Will This Time Be Different?
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Unless you have been living under a rock, you would know that the federal reserve is going to raise interest rates this year.
Over the last few weeks, I’ve noticed an increase in the number of posts assuring people that the rate-hike would not negatively impact the market and based on past performances, we can expect the market to continue going up.
While I am not here to predict how the market will behave in this round of rate hikes, I want to point out the flaws in blindly relying on past performances to project future returns expectations.
I will show you 2 reasons as to why the behaviour of the S&P market in this round of rate hikes may be different from its behaviour in the past and why you should not blindly rely on past performances to form your future expectations.
Without further ado, let us get started
1. Changes in the sectorial proportion of the “market”
The S&P has been around for over 162 years, and over this 162 you can be damn sure that the index itself had undergone numerous changes in terms of the companies that are included and the sectorial proportion of the index.
What this means is that the index that we knew of 50 years ago will exhibit a very different behaviour as compared to the index that we are all familiar with today.
The reason is that the companies that are listed within the index itself from the past and present are different both in terms of their nature of business as well as the industry it is in.
Just take a look at how much the sectorial proportion had changed from 1969 to 2019.
You will realize that in the past, the S&P is very heavily focused on the industrial, energy and consumer staple sector whereas the S&P today is more balanced in terms of the sectorial proportion.
In fact, over the years, growth sectors like your tech, financials and real estate had increased substantially in terms of their share in the index and these sectors are more sensitive to interest rate changes, unlike the more defensive sectors that are more dominant in the past.
As investors who are investing in the S&P index, you should be aware that the index changes almost every year. You should be aware of what these changes are and how it affects the nature of the indexes behaviour instead of blindly projecting the past into the future.
Moving on to my next point.
2. Outstanding valuation environment of that time
The next reason why the market may not behave the same as it did during the previous rate hike is due to the valuation environment that we are currently in.
Unlike the other previous rate hikes, you will realize that the valuation of the market that we are in today is significantly way overvalued than the long-term average as well as the majority of the valuation multiple we were in during the past rate hikes.
What this means is that, statistically, the is a lower probability for the market to perform well following the rate hike as we had done in the past as the current valuation environment is already very stretched.
If indeed, the market continues its upwards trajectory despite higher interest rates and lower business profits over the next 12 to 24 months, you should be very careful as to how you manage your portfolio as we are probably in the end game when that happens.
Solution: Focus on valuation and ignore the rest
So, what can you do or rather what should you do when managing your investment in a rising interest rate environment?
Macroeconomics forecasting is often associated with low levels of accuracy simply because the topic itself is too complex.
As an investor, you will be better off focusing on the fundamentals of the business that you are investing in and the price that you are paying for as both of these factors are within your control unlike macro-economic events like rate hikes.
Nobody knows how the market will behave a week, a month, a year from now but what you can know today is if the price you are paying for on your investment is over or undervalued.
Remember, price is what you pay and value is what you get.
Nothing good ever comes from overpaying for something regardless of how good the company might be. A good company does not immediately indicate a good investment opportunity.
So, there you have it, these are the two reasons why this time the market might behave differently as it had in the previous rate hikes.
To recap, the first is that over the last 50 years, the S&P composite had experienced significant changes in the sectorial proportion. As a result, the behaviour of the market had changed significantly as the S&P now is more dominated growth-oriented as opposed to the defensive sectors that were more dominant in the past.
The second is that in terms of valuations, we are currently trading at a multiple that is significantly higher than the long-term average AND the multiples during the previous rate hikes. As a result, there is a higher probability that the market will undergo a correction instead of marching upwards during the next rate hikes.
As investors, we should just focus on the things that we can control such as the fundamentals of the business that we invest in and ensure that we do not over-pay for any of our investments instead of trying to focus on macro-economic events that are beyond our control.
Daniel is a Licensed Independent Financial Consultant with MAS and a certified Associate Wealth Planner that provides:
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This article is meant to be the opinion of the author
This article is for information purposes only
This article should not be seen as financial advice
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