NEW YORK -- Interest rates are definitely on the way up, and hawkish remarks from Federal Reserve Chairman Alan Greenspan have some on Wall Street thinking they might keep climbing for some time.
If you're wondering how to protect your portfolio from the market declines usually associated with rising rates, you could take a hint from the past: Large and midcap companies have fared better than small caps, and growth seems to have an edge over value. Information technology and health care have been top performers, while telecom and utilities have fallen out of favor.
"It's logical that the sectors and companies that are heavily indebted would be hurt by rising rates, because the cost of their capital will go up," said Sandy Lincoln, chief executive of Wayne Hummer Asset Management.
Utilities, telecommunication business, and some large-cap value stocks, such as automotive companies, tend to make heavy use of the debt markets, Lincoln said. Rising borrowing costs combined with the slower growth associated with value stocks can seriously dent earnings. Smaller companies are also vulnerable, as they often rely on debt to push their businesses forward.
While it's not gospel, "history is a good guide," said Sam Stovall, chief investment strategist for U.S. equity research with Standard & Poor's.
There have been six periods since 1970 when the central bank tightened rates multiple times over a period of many months. On average, in the six months following the first rate hike, the Standard & Poor's 500 fell 5 percent, nine of the 10 sectors in the index posted declines and all but one of the 56 industries in existence for all six periods fell.
From a style standpoint, the growth group fell an average of 3 percent during the first six months of rate tightening, while value dropped 5 percent.
The hardest-hit sectors were interest rate sensitive financials, which tumbled an average 13 percent; industrials sank 12 percent; consumer discretionary stocks fell 11 percent; and utilities lost 10 percent.
Not surprisingly, health care, energy, consumer staples and materials - things that people use regardless of the economic climate - endured less daunting losses. But the only sector that saw an average gain was tech, thanks to a 6 percent overall advance in electronic instruments.
It's probably dangerous to extrapolate too much from that, as the tech sector has changed vastly over the last three decades, growing from just three industry groups in 1970 to 15 today. But there's good reason to think tech stocks could do well in the current climate, as long as their valuations are not too stretched, Stovall said. For companies hoping to maintain high productivity levels, investing in technology is cheaper than hiring more workers.
Rising rates cause the equity markets to suffer in three ways. Higher interest rates increase borrowing costs, which are a drag on corporate profits. Investor enthusiasm for stocks declines as bonds become a more attractive substitute. And ultimately, stock values fall, because rate hikes force the market to discount future earnings and cash flow.
If you assume the current economic trends will continue - stronger jobs growth, gradually rising inflation and flattening worker productivity - it's reasonable to expect a series of rate increases over the next 12 to 24 months. The market expects the tightening to begin after the Fed's June 29-30 meeting, with a quarter to a half percentage point rise.
Economists with S&P think the Fed will raise the federal funds rate - the interest that banks charge each other - by a total of 3 percentage points over the next 24 months. That would lift it off its current 45-year-low to 4 percent by the first quarter of 2006. The idea is to put the brakes on the rapidly expanding economy, and stay a step ahead of inflation.
While most analysts are confident that Greenspan and his fellow policy makers know what they're doing, periods of rising rates can be confusing, particularly for smaller investors. How you handle it depends on your tolerance for risk.
Aggressive investors who are willing to weather share price declines might want to bet on economically sensitive stocks, knowing they're likely to continue to slide. Those who are more risk-averse should gravitate toward defensive areas, such as energy, consumer staples and healthcare. But keep in mind, even these stocks are likely to stagger as rates go up.
"Don't panic when your stock prices start to fall ... even if you have invested in defensive areas of the market," Stovall said. "The advantage of defensive sectors is that they tend to fall less than the overall market during periods of rising rates, not that they'll post advances."
The Dow Jones industrials ended the week up 167.28, or 1.6 percent, finishing at 10,410.10. The S&P 500 index added 13.97, or 1.2 percent, to close at 1,136.47.
The Nasdaq gained 21.25, or 1.1 percent, during the week, closing Friday at 1,999.87.
The Russell 2000 index, which tracks smaller company stocks, closed the week 1.37, or 0.2 percent, higher, at 569.12.
The Wilshire 5000 Total Market Index, which tracks more than 5,000 U.S.-based companies, ended the week at 11,045.95, up 109.63 from the previous week. A year ago, the index was at 9,552.55.
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