How to Fed-Proof Your Portfolio

 

Protect Your Portfolio from the Fed
What To Own in December, and What To Sell
This Stock Goes Up When the Fed Moves

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Friday’s strong jobs report—which raised the probability of a December rate hike to around 70% according to futures markets—initially caused a sharp dip in the major indexes, followed by an end-of-day rally. However, that was followed by more dramatic corrections of about 1% in each of the indexes on Monday.

The market has developed a somewhat bipolar attitude toward interest rate hikes, alternately rejoicing about the strong economy and freaking out about the effect rate hikes could have on the markets.

You can be more level headed in your own investing—one of the major advantages of being an individual investor and a stock picker.

First, it helps to remind yourself of the actual effect of rate hikes on the stock market. Since 1983, the S&P has risen by an average of about 7.5% in the six months following the Fed’s first rate hike:

The dotted line in the middle of this graph represents the Fed’s first rate hike in six different tightening cycles, and the blue line represents the average performance of the S&P from four months before the hike to six months after.

(As an aside, that big dip in the S&P just under four months before the first rate hike is suddenly pretty interesting with this August’s crash now two-and-a-half months in the rear view mirror.)

The second way to outsmart the market about rate hikes is to know what types of investments do well in a rising rate environment, and which do poorly. There’s no need to sell everything every time Janet Yellen opens her mouth, despite what the market’s action might have you believe.

The biggest losers when rates rise are fixed income investments, particularly bonds. Existing bonds decrease in value when interest rates rise, because newly issued bonds have more attractive payouts. Bond funds tend to perform even worse, because funds owning bonds in a certain range of maturities have to sell bonds at lower prices to buy newer, more-expensive bonds.

Utilities, a favorite equity option for income investors, also get hit when rates start going up, because they have a lot of debt and because their stocks are alternatives to fixed income (which becomes more attractive as rates rise). But while I wouldn’t recommend owning a utility ETF in a rising rate environment, some individual stocks may still be appropriate for long-term investors, especially stocks of utilities with higher credit quality and fewer near-term debt maturities, and whose businesses are showing healthy growth.

Other investment types that often get hit in a rising rate environment are REITs, high yield investments, leveraged CEFs (closed end funds) and stocks of heavily indebted companies.

There are plenty of winners from rising rates as well. Commodity prices have a history of rising during tightening cycles, benefiting companies that are major producers of raw materials. Commodity stocks have been absolutely slammed this year, so there are plenty of incredible values available today. Copper and gold miner Freeport McMoRan (FCX), for example, trades at a forward P/E of 12 today, but could be a hot ticket after the Fed’s December meeting.

Financial companies also do well in rising rate environments, because they can charge more for loans, increasing the spread between lending rates and the rates they must pay on deposits. Bank presidents from the local savings and loan to JP Morgan are all awaiting rate hikes with bated breath.

Insurance company execs are also looking forward to the Fed’s first rate hike, because insurance companies can get much higher returns on their policy premiums when rates on fixed income instruments are higher.

In fact, one of the leaders of October’s market rally was a “stodgy” insurance company with a 2% yield. The Travelers Companies (TRV), a provider of car, home and business insurance, is hitting new 52-week highs these days after reporting stellar earnings in late October.

The company reported estimate-beating earnings and revenue numbers despite a 15% decline in net investment income. Just imagine what the company can do when rising rates start supporting strong investment returns again.

Travelers is also a reliable dividend payer. The company has paid dividends since 1992, and has increased the payout every year since 2009. The next dividend payment of $0.61 per share will be made to investors who own the stock before December 6 this year. And I expect the company to announce another dividend increase when it declares its next quarterly dividend in January.

For investors who like quarterly income and gradual capital appreciation, TRV is a good choice, and a nice hedge against the Fed madness currently consuming markets. And remember, if you want regular recommendations of other high-quality, dividend-paying stocks like Travelers, a premium membership to Cabot Dividend Investor starts at less than $10 per month!

Click here to see how much that gets you.

Sincerely,

Chloe Lutts Jensen

Chief Analyst of Cabot Dividend Investor

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