Investors are misreading the Fed

Wall Street could be wrong about the Federal Reserve in many ways. Stocks rocketed higher after the January 3 release of minutes from Fed policymaker's most recent meeting. Investors interpreted the minutes to mean the end of the central bank's 18-month streak of short-term interest rate hikes is near; the major indexes subsequently hit new 4 1/2 year highs on the assumption that once the Fed is finished raising rates, stocks will soar even higher. But investors shouldn't be absolutely sure about when the rate hikes will end or what that will mean for stocks.

The Fed minutes dropped language contained in previous statements that described interest rates as being too low, or accommodative. And the minutes said Fed policymakers differed on how many further rate hikes may be needed.

What they didn't say was, "We're wrapping this up." Instead, Business Week's interpretation of the notes put it succinctly: "We're not sure."

This exposition was bolstered by a Jan. 9 speech by Atlanta Federal Reserve president Jack Guynn.

"Given the steady diet of 'measured' rate hikes the Fed has provided in the past year and a half, many of you may be wondering when enough is enough," Guynn said. "Let me first respond by saying, the closer we get, the less explicit we can be on that point; it's my personal opinion that as policymakers we should resist the temptation to say more than we know at any given time."

Merrill Lynch's North American Economist David A. Rosenberg read the comments as "hinting for the first time that he does not know what the Fed will do next."

Guynn is on the Fed system's Federal Open Market Committee, which sets short-term interest rates. If he doesn't know, do you really think your broker does?

Mickey Levy, Bank of America's chief economist, has interpreted the Fed's latest notes to mean the central bank is entering a "data dependent" phase, in which it will set policy using the latest data, instead of entering each policy meeting with the conviction that rates are too low.

Linda Duessel, market strategist at Federated Investors in Pittsburgh, agrees that "data dependent" are the Fed buzzwords of the moment.

"Everyone thinks the Fed minutes told us they were nearly done," she said. "I don't think so. "We're watching wages," she said. "If wages start to go up, I think (incoming Fed chairman Ben) Bernanke is going to do what he thinks he needs to do." At some point, the rate hikes will stop. Wall Street's assumption is that when they do, stocks will climb even higher. Not necessarily, wrote Bank of America's Thomas McManus in a note titled "Popular view of 'what happens when the Fed stops' is based on too few cycles."

Looking at 20 separate tightening cycles over more than 50 years, he found that the Standard & Poor's 500 performed better, on average, in the year leading up to a peak in rates than it did the year after the peak.

"This should not be a surprise," he wrote, "as earnings are generally robust during Fed tightening, and the signals for the FOMC (Federal Open Market Committee) to move to the sidelines have typically included indications of a weaker economy, which can easily undermine stock valuations, even in a more supportive interest rate environment."

So, if the rate hikes end in 2006 and if the market sticks to historical patterns and performs worse than it did in 2005, then 2006 could be nothing special.

That's not to say the end of Federal Reserve short-term rate hikes will hurt stocks. McManus found that each sector of the S&P 500 provided positive returns, on average, in the 12 months after rates peaked, but only three sectors provided double-digit returns. Those three sectors were consumer staples, health care and financial stocks, which are traditionally defensive sectors, the ones that tend to do well when the overall market is weak.

Which it may be in 2006. Or, maybe not. Wise investors know that some things are unknowable reports the AP. D.M.