An old adage on Wall Street is three rate increases and you’re out.  If the Federal Reserve shifts toward restraint, stock values cannot perform well.  Three rate increases clearly reflect a policy shift.  Therefore, look out for the next bear market when the Federal Reserve restrains money growth. 

However, there is an exception to this adage.  If the Federal Reserve had been expansive in order to jar an economy out of lethargy and the Fed now is withdrawing that thrust, stock prices can continue to improve.  In a perfect world, investors would applaud this maneuver to sustain growth for an extended period of time. 

Of course, the world is not perfect.  Indeed, the current Federal Reserve’s strategy is flowed.  A measured removal of a subsidy could mean that the Fed is providing the least monetary thrust after the economy already has slowed to less than sustainable growth.  As no new tax initiatives are planned, we might have tightening monetary and budgetary policy during a period of slowing growth. 

Because of this apparent policy failure that may be brewing, I must consider the recession of late 2006, which will be anticipated by the stock market sometime in 2005. 

Nevertheless, quick action to remove the unsustainable monetary thrust still might prove timely, as it ultimately did in 1994.  Indeed, I would currently suggest that the odds are about even that we get it right and maintain sustained economic growth through the remainder of this decade. 

Let’s assume that is the case. 

Then we do not want to dump most of our stocks.  To be sure, the homebuilders, mortgage refinancers, home remodeling stores, some of the furniture and appliance companies and stores, and even the landscapers and housing related activity may be overdone.  A price pullback in those stocks could develop. 

However, investors sometimes believe that higher interest rates only compete with interest related stocks.  Thus, the high dividend stocks are seen as vulnerable.  Also, the utilities and financial institutions, which continuously pay relatively high dividend yields are under the gun.  REITs look especially vulnerable as an alternative to bank yields. 

Indeed, all of these issues fell sharply in 1994.  And then rallied in the next few years.  The smaller capitalized stocks that did not pay dividends performed well in 1994 and then lagged for much of the remainder of the decade. 

These patterns developed because the first assumptions about losing competitiveness to bank rates as interest rates rise is only a very small part of the equity issue.  If occupancy rates and rental rates are rising, then the cash flow of REITs is improving.  Not only can their payouts grow along with bank rates, but the value of their assets can continue to rise. 

If we achieve sustained growth, then many smaller companies can grow while risky credits can become well.  The next surge of segment growth could spurt in the latter part of this decade (although I am not smart enough to know what that segment is—perhaps pharmacological). 

Although investors are selling off all finance related companies, that is too simplistic.  To be sure, banks and finance companies that relied heavily upon mortgage refinancing will have some difficulties.  But many banks earn more on enterprise loans and mortgage and acquisition loans than they do on refinancing fees.  The latter will intensify.  Also, community banks will find at least a little rate increase a benefit in beginning to compete for bank deposits again.  The rates were so low that they could not pay the administrative and advertising costs to seek out deposits. 

As for insurance companies, the issue is in the risks.  If no unexpected risks surface, such as the twin towers disaster, then their premiums should cover their losses.  Then higher interest rates actually increase returns on their investments, raising the value of their enterprises. 

In a nutshell, some entities have benefited from low interest rates.  They will not do well as rates rise toward more normal levels.  However, good policy is to avoid the surge and sag economy that almost certainly will develop if rates remain at unusually low levels. 

Already, hedge funds are heavily into exploiting the “carry” (the gap between short term and long term rates).  This is possible because the gap is artificial.  If we are to avoid another Long Term Capital Management type scare, we need to remove these artificial conditions.  That is how we can get sustained growth. 

Frankly, I am seeing the current market stall as an opportunity to position my portfolio for sustained growth.  But, I wish the Fed would remove “measured” and replace it with “deliberate” in its actions as I also search for evidence that the 2006 recession is becoming more likely.