How You Should Prepare for Fed’s New Monetary Policy

How are you planning to adjust your portfolio as the Fed changes its monetary policy?

I just got back Sunday afternoon from our Total Wealth Symposium in Panama. I had space for just one workshop while I was there, and given the anticipation over rising interest rates, I decided to advise our attendees on how to prepare for the Fed’s market manipulation.

This discussion grows increasingly important, because as Jeff Opdyke and I have noted, the Fed is on the cusp of entering into a new era — an era of rising interest rates, albeit at a very muted pace.

As long as you understand that, you can better prepare yourself today.

It all comes down to a correlation Jeff shared with his readers of the Sovereign Investor monthly newsletter in June’s issue. The correlation, as simple and obvious as it may seem, explains so much about the future direction of the U.S. stock market.

This correlation is that price-to-earnings (P/E) ratios and interest rates have an inverse correlation. That means when interest rates rise, P/E ratios tend to fall — which, in turn, means investors are not willing to pay as much for stocks.

This tells us everything we need to know about the fallout from the upcoming policies that are coming down the pipe from the Fed.

The Fed’s Ongoing Game of Delaying the Inevitable

The markets were hooked last week as Fed Chair Janet Yellen held a press conference after the Fed’s two-day Federal Open Market Committee meeting.

Investors and analysts, including myself, were anticipating some degree of change in the language the committee used to describe its interest rate timeline from the “considerable time” phrase — but Janet Yellen stuck to the script.

She maintained her overwhelmingly dovish tone and avoided all the pressing questions about when rates would rise with her usual responses.

However, the fact remains — rising rates are coming … it is just a matter of when.

Of course, until we actually see policy action, all the talk about the Fed will be a well-thought-out guessing game. None of us really know what Janet Yellen is plotting.

So while we chew through all the data and analyze upcoming speeches from other members of the Fed, it is ultimately on Janet Yellen’s shoulders to decide when “when” will be.

This has Wall Street on the edge of their seats waiting on the Fed to make its move. All we have to go on is some ambiguous notion that the Fed will raise rates at some point in the future, with arrows pointing to sometime in 2015.

But that alone speaks volumes — enough to begin making long-term decisions about how to strengthen your portfolio against the upcoming market shifts.

Here’s why:

There is a basic formula that pretty much every analyst uses to value a stock — discounted cash flow. To be brief, it is basically valuing a company’s future cash flows at today’s value. And a key part of the equation is interest rates. As rates rise, the value of those future cash flows become worth less and less.

That explains why as interest rates increase, even at a gradual pace, we will see a contraction in P/E ratios.

But, as rates rise in a slow, sluggish economy, the ability to grow businesses profitably becomes increasingly hard — and that means earnings are likely to be compressed going forward.

Sounds a bit depressing, I know.

But here’s the upside.

Since you understand that P/E ratios are going to be on the decline, and earnings are going to be compressed, dividends are going to be your best friend as we enter into the next era of interest rate hikes.

Your best way to ride the volatility in the markets will be to add companies that are able to return more cash to shareholders each year. I would find companies that are increasing their dividend payments while they are also conducting share buybacks to reduce their shares outstanding — which helps boost earnings.

While it’s fine to find a company that is either buying back shares or increasing dividend payments, I like to find companies that can do both. That’s a tell-tale sign that a company is experiencing real, stable growth and it is confident enough to return increasing amounts of cash to shareholders.

As for the timing, here’s my best guess.

Don’t Wait for the Commotion

By gauging the Fed’s projections, which are basically released every other Fed meeting, we know that they are going to begin to raise rates fairly soon.

With 2015 as the expected target for when the Fed Funds rate is expected to creep toward 2%, the rate by the end of this year will still be well below 1%, even if we see a rise before then — all of which leaves the actual announcement about where rates head at the forefront of the minds that will move the market.

The next date to watch for a possible timeline on interest rates, and probably a knee-jerk reaction in stocks, is December 17 — which is when Janet Yellen will hold her next press conference. Plus, it seems like an ideal opportunity to lay out the expectations for interest rates in 2015.

We will likely see the broader markets higher in December than they are today, but as we get closer to December 17, I would advise taking some chips off the table before investors begin to reacting sporadically to rising interest rates and declining P/E ratios.

You will likely have a buying opportunity after the December Fed meeting — just be sure to focus on those stocks that return increasing amounts of cash to you.

Regards,

Chad Shoop
Editor, Pure Income

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