Stick or twist for equities

It now looks odds on that the Fed will be raising rates next year, and many fear this spells the end of the rally. With most stockmarket returns flat or in negative territory year to date, the question is: should investors sell equities now, before a new bear market sets in?
Both the Bank of England and the Fed may raise rates earlier than the market currently expects. Yet despite this, my advice is to stick with equities until the Fed actually pulls the trigger.
Looking at the S&P 500 index around the start of the past six Fed tightening cycles, on the day it announces the first hike of a tightening cycle, the market normally rallies in the run-up.
By contrast, returns tend to be flat or negative in the months after the first interest rate hike. Since 1977, the average rise is positive and above-trend for all the time periods, so whether the Fed raises rates in three, six, 12 or 18 months’ time, history suggests the US stockmarket will perform well.
This may not convince the pessimists who suggest equity valuations are stretched well beyond the average in recent years and cannot be sustained. Once again, the evidence suggests otherwise.
High inflation is associated with low price to earnings ratios and vice versa. The current PE of 17.1 is above the average of recent decades but that is because inflation is low. Indeed, given current US inflation of 1.5%, the S&P 500 is a little cheaper than average in terms of the P/E.
So what could go wrong? One of the cycles, in 1977, was the exception to the rule that the stockmarket rises ahead of Fed tightening. The Fed was behind the curve back then and let inflation rip. Lulled into a false sense of security by inflation, which had fallen sharply the previous year, and unemployment, which was high by the standards of the day, they delayed tightening and lost control.
They made the same mistake in the previous tightening cycle in 1974. The stockmarket returns before and after these tightening cycles were even worse when adjusted for inflation. Were the Fed to delay tightening again and let inflation rise to, say, 5%, I would abandon my optimistic view and sell. But there are good reasons why we can trust the US Fed to avoid such a scenario.
Janet Yellen is widely seen as a dove but I am confident she will do the right thing and tighten early to head off a significant rise in inflation. After all, she was at the Fed in 1977 and shares the deeply held view there that the blame for letting inflation get out of control in the 1970s lies with them, not OPEC or anyone else. She has learnt that valuable lesson and will want to avoid repeating the Fed’s mistake.
The message is that equity investors should not be afraid that it will raise rates later this year or in 2015. There would be a case for fearing that the Fed might not raise rates but I recommend they trust it to do the right thing. As I see it, the bull market is not over quite yet.