Don't Be Cavalier About a Fed Hike and Watch for These Warning Signs

 | Dec 12, 2016 | 9:00 AM EST
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It's almost show time for the Federal Reserve with respect to interest rates, and that should have every investor on high alert despite the amazing feelings associated with the market's post-Election Day euphoria.

When the Fed concludes its gathering later this week, it's likely to include the long-awaited second rate increase since the end of the Great Recession. Although Fed Chairwoman Janet Yellen is unlikely to morph into a hawk in time for her widely followed press conference, the truth is that she could provide a dose of reality to the stock markets now that the election is over.

If you look back at her comments in recent months, she has sounded a touch more hawkish on the direction of interest rates. The market has chosen to ignore her words, instead placing hope on the economic impact of any potential President Trump stimulus packages. But, a more hawkish Yellen certainly could surprise the many who have overlooked her comments.

In any event, investors need to remember what happened last year after the Fed raised interest rates. There was a delay in reaction, but then you know what hit the fan in January. Last January, the S&P 500 fell 5.1% and the Dow Jones industrial Average shed 5.5% for the biggest monthly losses since August and the largest January declines since 2009. The Nasdaq plunged 7.9%, its worst month since May 2010.

The moves to the downside were convincing, too, causing the selling to feed on itself after a while. January saw the highest monthly average Nasdaq Composite, NYSE Composite and total volume since August 2011. Why did this occur? It's pretty simple.

The market rationalized that the delayed effect (usually six months) of the Fed's first interest rate hike would crush companies in the second half of 2016. Investors, as a result, were trying to reduce their exposure to many overvalued areas of the market -- notably emerging markets and tech -- before Corporate America delivered surprisingly weak earnings and tepid outlooks.

The dire situations didn't pan out as the economy remained nicely resilient during an election year and companies continued to pursue stock buybacks and major acquisitions. First-quarter results for many S&P 500 companies in late January and February helped to quiet the litany of worries brought about by the horrible start to the year's trading.

That said, this Fed meeting should be watched carefully in order to try and avoid the brutal losses seen last January. Granted, the economy is in better shape and President Trump could provide several catalysts in early 2017. However, one must not underestimate the potential delayed impact on stocks from a Federal Reserve on track to be more aggressive with rates in 2017 than it was in 2016.

Here is what to watch to see if the market is secretly worried about the aftermath of the Fed's rate hike:

  • If large-cap tech names such as Microsoft (MSFT) and Facebook (FB) (which is part of Jim Cramer's Action Alerts PLUS portfolio of stocks) that have had stellar gains in 2016 sell off. It could be a sign of funds looking to raise cash to protect potential losses in January. 
  • If highly indebted, failing companies such as Sears Holdings (SHLD) sell off big-time. If that happens, it could be the market's way of saying its worried again about the Fed's impact on Corporate America, especially those companies that are struggling.
  • If home builders and derivative names such as Home Depot (HD) sell off, that could be a sign rate hikes should be respected (they weren't right after the rate hike last year). As of today, the general thinking is that home builders and related names -- and the economy at large -- could handle higher interest rates.

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