Scrapping With Ben

Story Highlights:

• Many believe Ben Bernanke's recent comments delivered the strongest indication yet that the Fed was finished lowering rates and may raise them in the future to quell inflation.
• A low central bank rate isn't a pre-requisite for a healthy stock market or economy.
• History shows stocks can do well in periods of steady and rising rates.

__________________________________________________________________________________________

It can't be easy to chair the US Federal Reserve these days. Folks hang on Ben Bernanke's every word, gesture…heck, if he sneezes it's analyzed. Poor Ben. Even his most benign comments initiate DaVinci Code-esque quests to find some "hidden meaning."

Mr. Bernanke spoke at a Fed conference Monday evening. Only after he noted the reduced risks of a significant economic downturn did he address inflation. Like hawks, the pundits swooped in, poaching Ben's comments with their razor talons. Back at their nests, the comments are swallowed and regurgitated as Tuesday's media prognostications and assumptions.

Rather than direct you to one of the countless interpretations, we advise reading Bernanke's comments for yourself: https://www.federalreserve.gov/newsevents/speech/bernanke20080609a.htm

Theories about interest rate fluctuations and their impact on stock markets are plentiful. Perhaps the best known theory is one phrased as, "Don't fight the Fed." In Wall Street terms, this means one should sell stocks when the Fed raises their "short rate," otherwise known as the Fed Funds Rate. Many believe this is especially apt after two or three consecutive rate increases. But is it really true? Do stocks perform poorly when the Fed is tightening? As investors, should we all back down from looming Fed rate increases?

No. More often than not, it's worth standing up to the Fed when they raise short rates. Simply review how the Fed-fearin' faithful fared during the mid to late ‘90s. The Fed increased short rates during this period, which meant true Fed-fearin' followers stayed away from stocks. Oops! They missed a raging bull market. How about the market from 2001 to 2003? Their mantra would have them invested in stocks, because the Fed steadily lowered rates during this period. Oops again! The period also included one of the worst bear markets in history. Of course, stocks don't always go up when rates are increasing, but on average, they do quite well—well enough to ignore "Don't fight the Fed" as a market myth.

Mr. Bernanke stirred up the stink Monday by stating the Fed would "strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation." Does this mean a rate increase is imminent and therefore also a prolonged downturn for stocks? Maybe so, maybe not.

The heart of the issue (for many) is whether short-term interest rates will go too high, cutting off capital flows needed for economic growth. The simple act of raising rates in itself won't realize this fear. Investors should note today's US short rates are effectively zero on a real (inflation adjusted) basis. Even a moderate cycle of rate hikes (say, back to the nominal five-ish percent of a few years ago) would still be well within benign territory. Put another way, the absolute level of interest rates matters, and today's levels are quite low.

But common sense alone should tell folks there are many other factors to consider when determining where stocks are headed. And Ben himself alluded the economy isn't as bad as many fear. (In fact, he didn't even go so far as to say inflation is a real problem, just that the Fed's current bias is towards that rather than economic growth.)

Relying on simple, widely known events like short rate movements to dictate your investment strategy won't cut it. Movement up or down in the Fed's short rate spectrum says little about future stock performance, and never has. That's empowering knowledge great for beating some sense into the heads of the Fed-fearin' faithful should the Fed start raising rates.