Will Raising Interest Rates Derail the Stock Market?

It is the single question that’s on the minds of most investors. What is the impact on the stock market if interest rates continue to rise?

My sense is that rising rates – off of a very low 0% Fed funds rate – will not harm stocks.

After all, the major stock-market barometers – the Dow, the S&P 500, the NASDAQ Composite – have all pushed forward to achieve new highs after the June interest-rate spike. Sure – stocks had pulled back briefly, but then resumed their climb.

If we take a more granular look, though, the answer is less obvious. Stocks are heterogeneous, and the share prices of companies in some sectors have recovered better than those in others.

The market rally has been mixed because rising interest rates are a mixed blessing. Rising rates increase borrowing costs. But they also increase opportunities in fixed-income investments, which have suffered a dearth of opportunity in recent years. 

Rising interest rates a sign of an improving economy. And the best thing for U.S. companies is a healthy economy. A healthy economy is far more important than low borrowing costs. And this is an obvious plus for stock prices.   

So who are the losers and winners when interest rates rise? 

Not surprising, sectors marked by high debt will likely underperform. When debt matures and must be refinanced, the cost to fund new debt rises and weighs on future earnings and dividend growth. 

For this reason, sectors carrying high debt levels have yet to rebound with the stock market.

Utilities, for one, carry high debt levels, and interest-rate worries continue to weigh on their share price. The Dow Jones U.S. Utilities Index (DJUSUT) is down 1.5% from late April – when interest rates first started to rise. In comparison, the broader market S&P 500 is up 7.5%. 

Similar underperformance is seen in other high-debt sectors. The Alerian MLP Index (NYSE: AMLP), concentrated in energy master limited partnerships, is up less then 1% in the past three months. And the Vanguard REIT ETF (NYSE: VNQ), a diversified commercial REIT fund, is still 2% below late-April levels. 

I'm not suggesting that investors sell MLPs or REITs. The High Yield Wealth portfolio continues to own energy MLPs, REITS, and utilities. But I’m focused on investing in individual stocks, not ETFs that follow these sectors.

I still like these “loser” investments because of their individual characteristics and advantages. But in a rising-rate environment, I'm monitoring them a little more closely.  

As for the other side of the ledger, banks are perceived as rising-interest-rate winners. But there is one caveat: Banks are winners as long as rates are rising but not inverting. Banks lend long-term but borrow short-term through customer deposits. When the spread expands, as it has in recent months, margins are projected to widen and earnings and dividend payouts are projected to rise. 

When interest rates took flight in late April, banks stocks soon followed. Investors, anticipating improved performance, have already bid up the KBW Bank Index (BKX) nearly 20% in the past three months. 

Technology stocks are also expected to outperform. Most tech companies have low debt and a stable fixed-capital structure, which leads to widening margins when revenue grows. In fact, the technology sector has historically been the best performing sector in the six-months after a rise in interest rates, according to data analyzed by JPMorgan and Birinyi Associates. 

Though not a sector per se, I'd be remiss not to mention my favorite investments – dividend growers.   

The SPDR S&P Dividend ETF (NYSE: SDY) is a fund composed of S&P 1500 stocks that have raised their dividends annually for at least 25-consecutive years. It’s up 6% since late April.

I'm not surprised. If there is one investment strategy for all seasons, it's a dividend-growth strategy. Whether investing in dividend growers through an ETF or by owning individual stocks like Altria or McDonalds, this is a tried and true strategy that rarely fails.

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