Rising Rates and Stock Styles
In last month’s blog Rising Rate Redux I looked at the total returns on U.S. stocks (S&P 500) and Canadian stocks (S&P TSX) in the months before and after the 1st rate hike by the U.S. Federal Reserve (Fed). As these are the standard market indices, think of them as the straight leg jeans in your wardrobe. But like jeans, there are more styles to choose from, and some will look better than others in the months after the 1st Fed hike.
Style Selection
I have added one more stock index, EAFE[1], to the straight leg section. I am also expanding the wardrobe to baggy (U.S. and Canadian value stock indices), flared (U.S. growth stock index), and skinny (U.S. small capitalization stock index)[2]. All of these can be implemented with low cost indexed ETFs[3].
Retro Look
I looked at the performance of each of the indices in the eighteen months after the 1st Fed hike. The data covers the seven tightening cycles from 1980, as outlined in the previous blog. Chart 1 below shows the average total return series for each index in Canadian dollars. An index moving from 100 to 110 is a 10% return.
Chart 1
Consistent with the results in the prior blog, six of the seven average total return indices peaked in month nine (green vertical line) after the 1st rate hike. Canadian value peaked in month ten. From month nine to eighteen (orange vertical line) returns were mixed, and ranged from slightly negative to slightly positive.
The average total return for each index from the 1st hike to month nine, and from month nine to eighteen, are detailed in Table 1. Only U.S. and Canadian value stocks and EAFE had positive returns in both nine-month time periods.
Table 1
Runway Returns
Chart 2 below debuts the full runway of index returns over the eighteen months after the 1st Fed hike. The vertical black bars showcase the range of returns for each index across the seven tightening cycles. The green diamonds show the average return for each index over all the cycles. The bottom of the chart shows the percentage of the cycles in which each index had positive returns.
Chart 2
The most attractive returns were for baggy (U.S. and Canadian value) and some straight leg (EAFE and Canadian) indices. EAFE had positive returns in all seven cycles. Value and Canadian indices were positive in six of seven cycles (86%). Flared (growth) was the fashion faux pau, with the lowest average return and only four of seven cycles (57%) having positive returns. Table 2 provides more details on the index returns from the 1st hike to month eighteen in each of the seven tightening cycles. In each column the dark green shading shows the highest return, medium green the second highest, and light green the third.
Table 2
Fashion Forward
The indices have been judged and the results are in. Baggy and some straight legged styles are the favourites over flares. Or in index terms, look to overweight value, EAFE, and Canadian and underweight growth in the 18 months after the 1st Fed tightening. This portfolio weighting will increase the odds of having the best dressed portfolio for 2022 and beyond.
Invest Wisely,
Dave Schaffner, CFA
Principal, Wayfairer Capital Management Ltd.
[1] The MSCI EAFE Index includes stocks in the developed markets of Europe, Asia, and the Far East
[2] I used the MSCI USA Value Index for U.S. value, the MSCI Canadian Value Index for Canadian value, the Russell 1000 Growth Index for U.S. growth, and the Russell 2000 Index for U.S. small cap.
[3] Sample ETFs: iShares XEF (EAFE), iShares IWD (U.S. value), iShares XCV (Canadian Value), iShares IWF (U.S. growth), and iShares IWM (U.S. small cap).