The beaches were closed here in the New York City area this past Labor Day weekend as the slow-moving and dangerous tropical storm Hermine approached the area. People were told to expect stormy conditions, strong winds and rain, and to prepare for flash floods.
After the devastation of Superstorm Sandy nearly four years ago, nobody wanted to take any chances. Fortunately, this time, the storm took a slightly different path than was predicted, and its effects on the city were more or less contained to the beaches.
So even though the sun was shining and the winds were calm, there weren't many complaints about the extra steps that officials took in response to the National Weather Service's (NWC) warnings. It's still prudent to be prepared for all eventualities rather than ignore the clear signs of an impending danger -- even if it might not materialize.
These days, it feels like it's the Federal Reserve that serves as some kind of National Weather Service for the stock market. The Fed does not know if there will be a storm -- but what Fed governors do know is that the market conditions might be changing, and they keep telling us as much.
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And why shouldn't we listen? While, like the NWS, the Fed watches the data and interprets its signals, the Fed is actually instrumental in translating data into actual policy. Plus, the Fed has the option of communicating policy changes ahead of time, a luxury that the NWS does not always have.
Take this year, for instance.
When the Fed hiked its short-term rate target last December for the first time since 2006, the market didn't like it. Stocks fell more than 10% through early February. However, after the bumpy start to the year, the market -- and especially interest-rate sensitive parts of it -- rallied to new highs. The sell-off proved to be a buying opportunity.
Now, after a series of strong employment reports and a pick-up in inflation, Fed officials are back to talking tough about "rate normalization." As data-watchers, they are likely to continue making their decisions based on headline inflation and employment reports. Based on the Fed Funds futures market, the probability of the rate hike this year is now 59.6%.
Still, the market assesses the likelihood of the next hike in September at a much lower 30%. So it looks as if investors have time to prepare -- and that's not even considering that, if economic data soften again, the Fed would likely continue to postpone any rate hikes.
How To Prepare For A Rate Hike
There isn't a single way to make a portfolio "Fed-proof" -- short of selling everything. But going to cash accomplishes nothing. Cash does not pay, and being out of the market carries significant opportunity costs.
If you decide to stay invested, then diversification should be your first line of defense.
Even though stocks are getting more and more correlated, some groups still act differently over longer periods of time. Among those groups, those most vulnerable to a potential sell-off if the Fed does restart the tightening cycle are so-called interest-rate sensitive stocks such as utilities, MLPs and REITs. So if the Fed does begin raising rates, then you should reevaluate your positions in any of these interest-rate sensitive stock groups.
There's also evidence to suggest that a portfolio would benefit from being exposed to lower-yielding quality stocks during a tightening cycle. While at first glance these do not seem to present an ideal income holding, it's important to keep in mind that stocks that pay solid but perhaps lower yields still generate income while also presenting the opportunity for significant income growth, even during a period of rising rates.
Many of the stocks in my premium newsletter, The Daily Paycheck, fit this definition, including names like Bristol-Myers Squibb (NYSE: BMY), Intel (Nasdaq: INTC) and Paychex (Nasdaq: PAYX). In fact, in July, Paychex hiked its dividend by 9.5%, giving the stock a yield of 3.1% -- still significantly higher than the benchmark 10-year Treasury note with its 1.7% yield.
Getting a little more defensive wouldn't hurt. But, unlike in years past, being defensive now means going easy on bonds. After a historic bull market in bonds, it's hard to envision a scenario in which they don't give up at least some of their gains.
Bonds and interest rates have a direct relationship: higher yields mean lower prices, and vice versa. Some bonds, however, are more sensitive to rate increases than others. It depends on several factors, the most important of which are maturity and quality. Bonds of shorter maturities are less sensitive to interest rate increases -- while longer-dated bonds are more volatile, all else equal. Further, bonds with longer maturities and low coupons would exhibit the most volatility in a higher-rate environment.
Another bond group that typically outperforms in this environment is junk bonds. That's because these lower-quality securities are leveraged more to the health of the economy (and, of course, the individual issuer) than to interest rates; also, these bonds typically have shorter maturities. They can also respond positively to a hike because coupons on these loans typically reset as rates rise. Therefore, it's not a bad sector to be moderately exposed to in the event of a rate hike.
If you're looking for more guidance on dealing with the perils of a rising interest rate environment, then I encourage you to try out my premium income newsletter, The Daily Paycheck. In each issue, my subscribers and I navigate the market to find bigger yields and more gains in a world of low yields and all-time high stock prices. If you're interested in earning thousands of dollars in extra income each and every month, then simply visit this link.