Will the Fed Put Coal in the Stockings of Equity Investors?

Euphoria has characterized the equity markets since the surprise election of Donald Trump. Most analysts, including me, predicted a sharp slide in stock prices and increased volatility if Trump captured the White House. Instead, since the market close on Election Day, the S&P 500 index value has risen over 5.6%. Most remarkably, the VIX index – a widely quoted measure of expected stock market volatility – has plunged by an astounding 37%. It seems that Trump has unleashed animal spirits in the stock market. Investors are optimistic because they are optimistic.

This is not to suggest that the recent stock market rally is all smoke and mirrors. Despite his protestations, President elect Trump is inheriting a reasonably strong economy, likely the healthiest since that welcoming Bill Clinton in 1992. Recent economic reports have been very positive. On an annualized basis, third quarter GDP increased at a 3.6 percent clip. While the President elect believes it is a bogus statistic, the official unemployment rate calculated by the Bureau of Labor Statistics stands at 4.6 percent. U.S. consumer sentiment, as measured by the University of Michigan, surged in November to its highest level in nearly two years.

Annually at this time, the financial media focuses on a concept dubbed “The Santa Claus Rally.” On average, the last five trading days in December and the first two trading days in January have historically provided higher than normal stock returns and lower than normal volatility of stock returns. As an aside, this effect is not limited to the U.S. stock markets. In the Journal of Financial Planning, Srinivas Nippani of Texas A&M University-Commerce, Ken Washer of Creighton University and I show that the Santa Claus Rally is pervasive throughout the world, even in countries where Christmas is not the leading holiday.

While it seems that many investors expect to experience a Santa Claus Rally closely on the heels of the unexpected Trump Rally, another market relationship may take precedence. As popular sports analyst Lee Corso likes to quip, “not so fast, my friend.”

Later this week, the Federal Reserve Open Market Committee meets and it is widely anticipated that they will raise the target fed funds rate by 25 basis points. Leaving rates unchanged would simply be shocking to the markets. In fact, the likelihood is that the Fed will hike rates further in 2017.

Rising interest rates have historically been unkind to the stock market. In Invest With the Fed (McGraw-Hill, 2015) Gerald Jensen of Creighton University, Luis Garcia-Feijoo and I found that from 1966 through 2013, when the Fed was hiking rates, the S&P 500 returned 5.9% on an annual basis. When rates were falling, the annual return was a robust 15.2%. Considering inflation, the real return differences were even greater. When rates were falling, the real return was 12.6% and when rates were rising it was a paltry 0.7%.

With rising interest rates likely, will Janet Yellen and her Federal Reserve colleagues be the Grinch that stole the Santa Claus Rally? As the last month shows, short-term stock market predictions are often dead wrong. But, as Mark Twain was rumored to have said, “history doesn’t repeat itself, but it does rhyme.” While it may not be felt immediately, Yellen is likely to have a greater impact on the stock market than Santa.

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