Beat the Heat of the Rising Interest Rates

When Federal Reserve Chairman AlanGreenspan suggested recently thatshort-term interest rates might soon beon the rise, the stock market reactedinstantaneously, with the Dow falling 109 points duringa span of several hours. And while Greenspanindicated no timetable for an interest rate increase, themessage was clear: Interest rates will rise again, andthey might do so before the end of this year.

Barron's

According to an article in , rising interestrates are bad news for stocks because "they imply anoverheating economy and resurgent inflation." Inaddition, rising interest rates also mean greater bondyields and, thus, increased competition for investordollars. But despite Greenspan's suggestion, not everyoneis predicting gloom and doom.

Historical Perspective

Market researchers point out that the fed is wellaware of the current state of the US economy, whichincludes high unemployment and global overcapacity.It knows that a rise in interest rates could trigger asignificant slowdown in consumer spending. Researcherstherefore anticipate that any action taken bythe fed will be judicious.

Perhaps of greater importance is that the 80-yearhistory of the stock market, which includes 22 periodsof low interest rates, shows that the market rallied onseveral occasions following the fed's initial interestrate hike. In other words, the anticipation of an interestrate hike affected the market more severely thanthe actual hike.

However, according to the Barron's article, troubledoes arise when the initial interest rate hike is followedby subsequent increases. For example, the fedhas instituted a second interest rate increase 16 times,and each time the Dow dipped an average of 2.73%over the succeeding 3 months and rose only 3.04%during the next 12 months.

Investors Beware?

While an interest rate hike doesn't signal panictime, it should be a signal for preparation. Sector rotationhas been an effective way for investors to minimizethe effects of rising interest rates. For example,defensive stocks such as consumer staples tend toweather interest rate increases better than shares ofcapital goods and other cyclical companies. That'sbecause even in tough economic times US consumersstill need to purchase everyday necessities such asshaving cream and laundry detergent.

Barron's

The article cites a recent study by EdwardYardeni, chief strategist for the Prudential EquityGroup, on the performance of different stock sectorsfollowing 9 periods of reduced interest rates since1960. From the study results, Yardeni was not onlyable to highlight which sectors to overweight andwhich sectors to underweight when interest ratesbegin to rise, but he was also able to determine theappropriate time to do so.

For example, Yardeni suggests that investorsshould immediately underweight in classic cyclicalsectors such as auto manufacturers, homebuilders,household and appliance firms, and makers of constructionand farm equipment as soon as rates beginto rise. Poor immediate performance can also beexpected in the railroad and electric utility sectors.

Worthy Considerations

Barron's

How can you tell when rates will begin to rise? Inthe article, Yardeni notes that the propertyand casualty insurance sector "seems to anticipate theonset of higher rates by several months." As such, itcould be the bell weather you're looking for.

Other sectors to consider

In which market sectors should you begin to stockup as interest rates rise? Yardeni points out that brewersand soft drink manufacturers have held up well inthe wake of rising interest rates. Therefore, overweightingin these two sectors should begin immediately.: tobacco, food retail, packagedfoods and meats, paper and forest products, chemicals,pharmaceuticals, and health care equipment.

Experts disagree as to exactly when interest rates willbegin to rise. Martin Barnes of the Montreal-based firmBank Credit Analyst doesn't think the fed will seriouslyconsider raising rates until late 2005. Others say the ratehike could come as soon as the latter part of 2004.Regardless, when it comes to interest rates, what goesdown will eventually go back up. Being prepared is thebest action you can take.