Why Fed rate hikes may not hurt stocks—this time

Trader on the floor of the New York Stock Exchange.
Adam Jeffery | CNBC
Trader on the floor of the New York Stock Exchange.

Despite the hand wringing about higher rates, stocks could actually rise when the Federal Reserve embarks on liftoff from its zero- rate policy, especially if it keeps the increases gradual.

The conventional thinking holds that stocks may not have an immediate reaction, but the market could pull back after the first few hikes. However, a study by Ned Davis Research found that a slower pace of hiking could change that outlook for equities and the market could continue to rise, if the Fed hikes at the slow pace it promises.

The average gain for the S&P 500 one year later was 10.8 percent during slow cycles, compared with a decline of 2.7 percent in fast hiking cycles, according to the study.

A slow pace of Fed hikes should mean slower increases in Treasury yields, which theoretically would be more easily digested by the stock market. A fast move higher, on the other hand, could result in asset reallocations away from stocks, as higher yielding instruments look more attractive.

"The fact that interest rates are starting at a low level should be taken into account," said Ed Clissold, Ned Davis U.S. market strategist. "Even after a few rate hikes, any relative valuation measure would still favor stocks over bonds."

Low yields on U.S. Treasurys already encourage allocation toward equities, especially as those yields are among the highest globally for developed market government debt.

Easing into higher interest rates also indicates there's less froth in the economy.

"It would stand to reason that if the Fed is going to slow, they are not anxious to slow the economy in order to fight escalating inflation, rather just tap the brakes a bit, which would still allow the economy to grow at a reasonable pace and therefore enable stocks to do relatively better than if the Fed was pushing hard on the economic brakes," said Brad Sorensen, director of market and sector research at the Schwab Center for Financial Research.

Schwab's midyear report highlighted the Ned Davis study on stock performance during central bank tightening.

In addition, John Lonski, chief economist at Moody's, said a gradual pace of tightening diminishes concerns that interest rates will suddenly shoot up and affect companies' ability to generate profits, whether through increased borrowing costs or decreased consumer spending.

Traders increasingly expect a rate hike as early as September. Whether that's a single, 25-basis-point increase or the start of a longer trend, the pace will likely differ from the last tightening cycle, which saw consecutive rate hikes for a total of a 425-basis-point increase between 2004 and 2006.

A "fast" cycle describe a series of hikes in successive central bank meetings, the Ned Davis study said. That quick pace is true for seven of the eight tightening cycles since 1967.

Fed talk points to a slow cycle this time. As Fed Chair Janet Yellen emphasizes, investors should focus on the pace and not the timing of rate hikes. Those remarks helped stocks rally slightly, as did lower median rate targets for 2016 and 2017 in the policymakers' "dot plot."

"The speed of interest rates increases matters," Clissold said. "During slower tightening cycles, investors have a chance to adjust to a rising interest rate environment. During faster cycles, investors may be behind the curve constantly."

But even after a six-year bull market, some strategists say the long-term outlook for the stock market remains bullish regardless of when or how quickly the Fed raises rates.

Read MoreCiti economist: Fed is too chicken to hike rates

"If you're a long-term investor you should look through (the rate hike)," said Robert Pavlik, chief market strategist at Boston Private Wealth. "That's how I'm advising people and handling my clients' money."