How to outsmart the Fed at its own game

Matt Krantz

Don't fight the Fed. You know that. But maybe investors can outfox the central bank.

Wall Street is bracing for what could be a radical shift in the playing field for investments ranging from stocks to bonds to commodities and real estate. The Federal Reserve meets this week and some investors expect it to boost short-term interest rates — kicking off the first tightening period in more than a decade.

Here is how markets usually react to this important shift, and a few guidelines for how to profit from it:

Janet Yellen
Getty Images

* Respect the importance of the move. A tightening by the Fed puts a chilling effect on stocks — and it happens fast. The Standard & Poor's 500 has seen its average gain shrivel to just 2.4% in the six months following the initial Fed rate increases going back to 1971, says Sam Stovall of S&P Capital IQ. That compares to the 9.5% average gain in the six months headed into the hike.

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The danger to stock returns is a real one. The S&P 500 delivered average 5.9% annualized returns when the Fed was "restrictive" and raising rates between 1966 and 2013, says Robert Johnson, president of the American College of Financial Services and co-author of Invest with the Fed. The big problem is that during those periods inflation was 5.1%, meaning investors only got a 0.8% annualized real return. In contrast, during expansionary times when the Fed was lowering rates, stocks turned in an annualized gain of 10.6% when inflation averaged 4.2%, Johnson says.

* Don't abandon stocks completely. Some investors make the mistake of thinking the higher rates are so toxic to stocks that they should bail out completely. History shows, though, that there are good places to be. Energy, consumer goods, utilities and food stocks outperform during periods the Fed is tightening rates, Johnson says, with average annual returns of 11.5%, 8.4%, 7.8% and 7%, respectively.

* Avoid the bond-fear hysteria. Investors get petrified of bonds when they think interest rates will rise. It's true bond prices fall when this happens. But the fears are a bit overstated when examining what's actually happened. The average return on the 10-year Treasury note during expansionary periods, 6.4%, is practically the same as the 6.3% during restrictive periods, Johnson says.

But there's a danger to bond investors that is less apparent. Inflation during restrictive periods has averaged a 5.1% vs. 2.9% rate during expansive periods, Johnson says. So while bond returns steady as rates rise, the higher inflation erodes the value of the fixed payments. The key, Johnson says, is to move to bonds that mature in a shorter period of time to reduce risk.

* Commodities are a surprise safe haven. The Goldman Sachs Commodity Index has been a stellar performer when the Fed raises rates going back to the 1970s, Johnson says. The index jumped 17.7% on average during restrictive periods compared with 0.2% average declines when the Fed is cutting rates. During times of inflation investors like hard assets.

* Take another look at emerging markets. Fears of a slowdown in China have pummeled emerging markets stocks. But these stocks could be compelling if historical trends return when the Fed boosts rates. Emerging markets stocks have gained 16.5% during restrictive periods — nearly twice their 8.5% gains during expansive periods, Johnson says.

A general view of the Federal Reserve Building in Washington
Poll: When will the Fed raise interest rates?

* Real estate requires careful attention. Real estate is often described as a single asset class, but investors are advised to understand the nuances of different markets as the reactions to rates are very different, Johnson says. Equity real estate investment trusts — which own everything from apartment buildings to commercial real-estate — do well during times of Fed hikes, just not as well. The average gain of equity REITs during restrictive periods is 9.8%, Johnson says. That's down from the 16.4% average gain during expansive periods.

What's the bottom line? "Rising rates cannot be ignored," Johnson says.