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@theMarket: Higher Interest Rates Pressure Stocks
By Bill Schmick, iBerkshires columnist
03:31PM / Friday, October 21, 2022

It was a week that looked promising. The three main U.S. averages spiked higher, gaining almost 4 percent in two days on no news. The remainder of the week saw profit-taking. Blame higher interest rates and a stronger dollar. 
 
The benchmark yield on the U.S. 10-year Treasury bond has topped 4 percent this week and hit 4.3 percent on Friday. The greenback climbed higher as a result. It is about one percent below its year-to-date high on the U.S. Dollar Index (DXY) of 114.78. As interest rates and the dollar continue to climb higher, stocks can still go up, but only to a point. We have reached that point this week.
 
The impetus for these rising rates is the bond market's belief that the Federal Reserve Bank will be unrelenting in its promise to raise interest longer and higher than the equity markets had hoped. Underlying this belief is the continued strength of the economy and the persistent strength in the inflation rate. Nothing in this statement is new. So why do both the bond and stock markets continue to ignore that fact?
 
I believe there is a hidden conflict among traders and investors that explains this divergence. It has its roots in the underlying, short-term behavior of equity and fixed income traders today versus the longer-term approach of the Fed.
 
This is understandable given the nature of the markets. Bond investors historically have thought in terms of months to years. That has changed somewhat as young, inexperienced, bond vigilantes attempt to push interest rates up and down rapidly. Many argue that the volatility in the bond market outstrips that of the stock market.
 
That is more difficult to accomplish given the depth of assets in the bond markets. In short, it takes a lot more money to move bonds around than it does stocks. However, applying leverage can amplify price movements.
 
In comparison, the Federal Reserve Bank thinks in terms of years. Inflation is high, and in their view, it will take anywhere from a year to three, or more, before they can manage to bring inflation down to their stated target of 2 percent. No matter how many ways they express those sentiments to market participants, investors, fail to believe them. Why?
 
Equity and bond players, I believe, have become increasingly short-term in their trading behavior. Generally, 70  percent of them (day and algo traders) are immersed in trading where the time horizon is in minutes, if not seconds. Long-term to them is, at best, a couple of weeks. Why is that significant?
 
The markets have been in a downtrend since December of last year. The decline has tried the patience of these new financial jockeys. They simply do not have the temperament to accept the longer-term perseverance that is required in these troubling economic times. They might be able to accept that the Fed will continue to raise Fed funds to some terminal rate of 4.5 percent or so, but then what?
 
The mistaken assumption is that the Fed will immediately start reducing interest rates again. What if interest rates simply remain at these higher levels for much longer? Most traders can't conceive of that happening. What if interest rates remain elevated for a year, maybe more? If so, we may face declining markets at worse, or sideways markets at best for longer than many might expect. 
 
For someone who began his financial career in 1979, I know how dreadful a sideways market can be. At the time, I think the S&P 500 Index gained a total of 26 points from 1979 to 1982.
 
From a technical point of view, we are still in a downtrend, and to see markets do what I want, we need to get above 3,800 on the S&P 500 Index by 20 points or so. I believe we will see that happen over the next week. However, we could easily see a hundred points or more down before that happens. 
 
How high could we go if I am right? A guess on the upside would be as high as 4,100-4,200, over a few weeks.
 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.

Anyone seeking individualized investment advice should contact a qualified investment adviser. None of the information presented in this article is intended to be and should not be construed as an endorsement of OPI, Inc. or a solicitation to become a client of OPI. The reader should not assume that any strategies or specific investments discussed are employed, bought, sold, or held by OPI. Investments in securities are not insured, protected, or guaranteed and may result in loss of income and/or principal. This communication may include opinions and forward-looking statements, and we can give no assurance that such beliefs and expectations will prove to be correct. Investments in securities are not insured, protected, or guaranteed and may result in loss of income and/or principal. This communication may include opinions and forward-looking statements, and we can give no assurance that such beliefs and expectations will prove to be correct.

 

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