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To chart investment future, look to past

With interest rates creeping back up, is it time for investors to head for the hills? The truly nervous already are camping on the sidelines, waiting for the turmoil in the stock and bond markets to settle down.

The rest of us have a tough job trying to decide whether to join them. We know that just when you think you've got things figured out, the markets usually deliver a big surprise _ even if you're Federal Reserve Board Chairman Alan Greenspan.

The Fed cannot directly influence long-term interest rates. However, Greenspan was convinced long rates would drop in response to the Fed's decision last month to boost short-term rates from 3.0 to 3.25 percent. To his dismay, long rates rose even more than short rates. Bond prices sank and stocks followed.

With the future looking so murky even to the experts, this might be a good time for a glimpse in the rear-view mirror. What happened in the past when the Federal Reserve Board started tightening the screws, making it more expensive to borrow money?

The answer is that bonds usually took a hit, but, surprisingly enough, stocks usually didn't.

Ryan Labs of New York looked at investment returns during six periods of Fed tightening dating back to 1958. The company found that the average total return during the first year of tightening was 4.6 percent for cash, 1.97 percent for bonds and 15.55 percent for stocks. The numbers include dividends or interest plus change in price.

Stocks were the best performer in four of the six periods, with the biggest gain a 43.4 percent return in 1986-87.

Stocks were losers in two of the periods, with the largest loss a 12.7 percent drop in 1961-62. That period was the only one in which bonds beat both stocks and cash, albeit with a meager 3.78 percent total return.

History indicates that it takes more than one or two increases in the federal funds rate, the cost of overnight loans between banks, to derail a bull market in stocks.

"The first rate increases usually don't amount to anything," said Sarasota money manager Ray Hines, who publishes an investment newsletter, the Wall Street Generalist.

The underlying reason is that the Fed begins raising short-term rates in response to an improving economy in order to keep inflation from heating up.

If the economy is getting better, corporate profits usually are too, which means conditions are favorable for stocks.

Later on in the rate-increase cycle, the economy and corporate profits are more likely to be peaking and inflation rising in spite of the Fed's best efforts.

Bonds, on the other hand, rarely benefit from rising short-term rates. While Greenspan expects the increase in short-term rates to cure inflation, the buyers of long-term bonds are skeptical. They expect to be rewarded by higher yields for the risk they are taking by buying a bond that doesn't come due for 20 or 30 years. When yields go up, bond prices go down.

Furthermore, history indicates that the Fed doesn't stop with just one rate increase. A Citibank study found that in previous periods of tightening, rates rose an average of nearly 2 full percentage points in the first year _ and kept going up from there. Many people expect the Fed to raise rates again this month, perhaps as soon as this week.

If history were all that mattered, we could all sell bonds and buy stocks and expect to come out ahead. However, the choice is not that simple because no two periods in history are exactly alike. We cannot say for sure whether we are in a period more like 1986, when stocks soared and bonds dropped, or more like 1961, when stocks plunged and bonds muddled through.

For one thing, inflation really isn't much of a problem just yet. And if it never gets to be a problem, interest rates might turn around, especially if the economy slows down again. Ultimately, Greenspan might turn out to be right about long-term rates.

"Right now it's like people are turning every rock along the path to find this inflation devil that we're all worried about," said Marcos Jones, senior economist at Raymond James & Associates Inc. "We misread inflation statistics or make them out to be more reliable than they possibly can be, but so long as there's any room to believe that this inflation problem is real or coming, we're going to stay in this sort of funk."

He is convinced the economy will become weaker and interest rates will reverse direction. So is Hines. They both expect the economy to be hurt by higher tax rates on the wealthy and the shrinking of the federal deficit.

"We're in uncharted waters," Hines said. "It would be very dangerous to assume any precedent here. There is secular change and people aren't aware of it. They're trying to judge based on the normal business cycle."

He says this is a good time to buy bonds and stocks. A more cautious assessment comes from David F. Scott Jr., business professor at the University of Central Florida.

"Logically, you have got to say that we're going to see a series of jumps in the federal funds rate," said Scott, executive director of the Dr. Phillips Institute for the Study of American Business Activity. "Stocks are a boxing match. We've got to see the corporate earnings be so strong that they overcome higher borrowing costs. I'm unprepared to say which way the fight's going to go."

All the uncertainty is a big reason both the stock and bond markets have reacted so violently to a relatively puny increase in the federal funds rate.

The Dow Jones industrial average, which had been flirting with 4,000, plunged 96 points when the increase was announced Feb. 4 and still hasn't fully recovered. Friday it closed at 3832.30.

The yield on the 30-year Treasury bond, which hit a low of 5.77 percent in October, is now up to 6.83 percent. A 1 percentage point increase in rates translates into a 5 to 10 percent decline in the share prices of long-term bond funds.

The situation, though painful for many investors, does have its its bright side. The reason Greenspan was prompted to act is that the economy is growing, consumers are buying and workers are finding jobs.

When the Fed gets tough

Here's what happened when the Fed began increasing the Federal Funds Rate

Month Rise after Total rise

tightening Low One year Two years How long How much


May 1958 0.63% 2.27% 3.22% 24 Mos. 3.22%

July 1961 1.16 1.55 1.86 97 Mos. 8.03

February 1972 3.29 3.29 N/A 19 Mos. 7.49

January 1977 4.61 2.09 5.46 53 Mos. 14.49

February 1983 8.51 1.09 N/A 18 Mos. 3.14

October 1986 5.85 1.44 2.45 29 Mos. 4.00

Average 1.96 3.94 6.73

Investment returns in the first year of tightening


tightening began Cash 1 Bonds 2 Stocks 3

May 1958 1.78% -5.67% 37.29%

July 1961 2.35 3.78 -12.65

February 1972 3.99 3.54 14.85

January 1977 5.12 2.08 -7.18

February 1983 8.88 8.85 17.62

October 1986 5.47 -0.79 43.36

Average 4.60 1.97 15.55

1 - One month T-bill. 2 - Ryan Labs Treasury Composite. 3 - S&P 500.

Sources: Citibank, Ryan Labs