Dow 2015: Will an Early Fed Rate Hike Start the Next Bear Market?

Dow 2015: Will an Early Fed Rate Hike Start the Next Bear Market?

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

The Dow Jones Industrials owe much of their huge gains over the past five years to the Federal Reserve's low interest rates. But the debate captured in the latest set of Fed meeting minutes about when the central bank should start raising interest rates reminded investors that at some point, they'll have to deal with a more normal rate environment. Even though most people don't expect the central bank to start moving until late 2015, smart investors are already trying to anticipate what impact tighter monetary policy could have on the Dow and the stock market generally.

How the Fed helped the Dow
Many investors rely on interest-generating investments in order to get enough cash to pay their living expenses. But by setting the federal funds rate near zero and implementing quantitative-easing policies to bring down rates on longer-term bonds, the Fed spurred investors to abandon bonds in favor of dividend-paying stocks that boasted higher yields than bonds and bank CDs could deliver. Increased demand for stocks -- and especially high-dividend stocks -- helped send the Dow and the rest of the stock market higher.

The Dow shows that phenomenon particularly well. The conservative investors who were most inclined to own bonds weren't entirely comfortable with the risk of the stock market. In order to minimize their risk, they gravitated toward less-volatile stocks with defensive characteristics. Within the Dow, Procter & Gamble , Johnson & Johnson , and Coca-Cola have seen their valuations soar, with earnings multiples around 20 despite many expecting slower growth from the three stocks than more traditional high-growth companies.

What's next?
When the Fed starts raising rates, bonds will look more attractive, and some investors will choose to sell off riskier stock holdings in order to lock in the security of higher bond rates. But there's reason to believe that the exodus from the stock market won't happen right away, as most investors will be reluctant to jump into a poor-performing asset class.

In 2013, bond investors got a hint of what happens when interest rates rise. In a short two-month span in the middle of the year, even the prospect of future tapering of quantitative-easing bond-buying caused rates to soar, and that produced big losses for bond exchange-traded funds and mutual funds. With those poor returns in their recent history, bond funds could have trouble attracting assets even when yields start to rise.

The danger, though, is that those investors who are least comfortable with stocks could pull the trigger and move back to bonds regardless of that risk. If that happens, Coca-Cola, Johnson & Johnson, and Procter & Gamble might find themselves in the unusual position of seeing their shares fall more than the overall Dow. Given the influence those stocks have on the Dow, the Fed's rise could very well create a ripple effect that could prove problematic for the bull market -- if something else doesn't send stocks falling first.

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Dan Caplinger has no position in any stocks mentioned. The Motley Fool recommends Coca-Cola, Johnson & Johnson, and Procter & Gamble. The Motley Fool owns shares of Coca-Cola and Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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