Are the Market's 'Taper Tantrums' Justified?

By Richard BarringtonLifestyle and

Though the stock market continued to roll along in July, some of its most troubled days in recent months have occurred as a reaction to signs that the Federal Reserve might start to taper its stimulus measures. Pundits have dubbed these negative reactions from the stock market as "taper tantrums." The question is, are these tantrums justified?

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A looked at how the stock market has performed during several Fed policy environments suggests that the taper tantrums might be an overreaction -- unless the Fed goes too far in reversing its low interest rate policies.

Why the taper tantrums?

Why is the stock market so sensitive to interest rates? Interest rates are widely used as a discounting mechanism for valuing stocks. The higher interest rates are, the less valuable the future earnings of a stock are, because an investor would be sacrificing that higher rate of interest by investing in stocks.

The sensitivity to Fed policy is heightened now because not only have they driven short-term interest rates down to nearly zero, but they have also taken the extraordinary measures of buying Treasury and mortgage-backed securities to drive long-term interest rates down. Any tapering of these stimulus measures is likely to result in higher interest rates across the board. Indeed, just the discussion of tapering has driven Treasury yields higher.

However, despite the role of interest rates in stock valuation, the outlook is not quite as simple as saying that if rates rise, stocks will struggle. In many cases, rates rise during a period of economic strength, when rising stock earnings can offset the rise in interest rates. In other words, stocks can withstand rising interest rates, if the economy is sufficiently strong and rates don't rise too fast.

What history says about it

The Federal Reserve provides history of the federal funds rate back to the mid-1950s. Comparing changes in the federal funds rate to concurrent price changes in the S&P 500 shows that what stocks really like is neither rising nor falling interest rates, but stability. In fact, the picture is surprisingly symmetrical:

The average 12-month price change for the S&P 500 over the entire period was 7.98 percent. So, what the chart above shows is that when interest rates change a great deal, stocks struggle. They are just slightly below average during moderate increases or decreases in rates, and stocks thrive when interest rates are reasonably stable. This suggests that the Fed has room to ease rates up gradually without crippling stock performance.

The inflation wild card

Why would the Fed be anything but gradual in its approach to raising interest rates? The one thing that could force its hand is inflation. The sharpest increases in the federal funds rate occurred during the high-inflation era of the 1970s and early 1980s. So, as closely as the stock market is watching the Fed these days, it should be keeping an especially wary eye on inflation.

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