Investors are getting worried about what Janet Yellen will say in her speech at Jackson Hole tomorrow and they're selling stocks. Dumb. That's the wrong move. It's not something you want to do. I'm sure some people sold stocks last December, too, when the Fed raised rates for the first time in nine years. The S&P tumbled for one day, then climbed more than 100 points to where we are today, just below 2200.
Same thing's probably going to happen this time around. Stocks will drop as nervous investors sell, but the selling is based on misguided thinking. On the other hand, for investors who understand the macro effect of interest rate changes, the selling will be a gift. You have to buy into any dip that occurs if and when the Fed raises rates or any dip based on a fear of that happening. In both cases, it's selling based on irrational fear.
I've been through this so many times. The government is a net payer of interest. Last year, it paid out $233 billion in interest on Treasury securities. That's more than it paid on Education Department programs or federal salaries and nearly as much as what it paid to defense contractors and Medicare parts C & D. It's no small number.
In addition, the Fed pays interest on reserves and current reserves are $4 trillion. A quarter-point increase in rates equates to an additional $10 billion per year in interest income paid. Two rate hikes and that's already $20 billion.
Sure, the income is not spread out equally, but it still adds to national income. Some of it does get spent and that means higher consumption, higher investment, higher corporate profits, etc. That's not a bad thing for stocks.
I realize there is also a relationship between interest rates and stock multiples. When rates come down, multiples go up, meaning stock prices can rise without a corresponding increase in earnings. That's what we have seen as a consequence of all the rate cutting and asset purchases over the years. That's also the reason why we hear so many folks saying the market is "overvalued."
On the other hand, when rates rise, stock multiples tend to come down. They come down because earnings rise as a consequence of higher income flow to the economy. The "e" in p/e gets larger, so the multiple shrinks.
I've used the example in the past of the Reagan "boom." Back in Ronald Reagan's first term as president, interest expense was the largest single line-item expenditure of the federal government. Stock prices rose. Yes, tax rates came down and that added to income, too, but it's all the same: It's an income effect. You raise incomes and the economy becomes bigger. National income and national output are one in the same.
I am not worried about a stock market decline when the Fed raises rates. Stocks will only be in trouble if income is sucked away, not when it is added. That can happen, too -- the sucking-away part, and we gotta be on the lookout for that.
The good news is, Congress tells you when it's going to take away your money. They do that either by raising taxes or cutting spending or both. Actually, even when they tax more it's not necessarily bearish for stocks as long as they recycle that taxation back into the economy in the form of spending. It may change the way the economy looks, but it doesn't diminish its size necessarily. On the other hand, when they cut spending, yeah, that shrinks the economy.