Market Insider

Fed could pump some life into aging bull market

Goldman's Hatzius: Most important thing to watch amid Fed meeting

Fed rate hikes are not necessarily bad for stocks, at least at first.

If history is a guide, the start of the hiking cycle may even be good news for those who fear the more than 6-year-old bull market is on its last legs. Stocks were sharply higher Tuesday on the eve of an expected Fed rate rise Wednesday afternoon — the first in nine years.

"It's a matter of time frame. It's very clear that the first Fed rate hike does signal the end of the bull market, but on average that end has come two years later and 33 percent higher with a low range of nine months and 10 percent," said Julian Emanuel, equities and derivatives strategist at UBS. "We fully believe we are going to see new highs in the indexes in the next six months, if not far sooner."

Emanuel studied rate hike cycles going back to the 1970s, measuring the gains and duration until they each topped before ending in bear markets. He eliminated the 1994 cycle since the market never officially entered a bear market before the next period of rate hikes.

Some strategists expect the Fed rate increase to launch the market on a Santa rally into the new year if the central bank does as expected. The consensus is the Fed will lift rates from zero by a quarter point, and softens its message by promising a slow path of rate hikes.

"Our feeling is technically speaking, with (stocks) getting oversold into what is usually a seasonally strong time of year, that we will get a positive response," said Ari Wald, technical analyst at Oppenheimer.

Raymond James strategist Jeffrey Saut on Tuesday said stocks are so oversold that they could be in for a "rip your face off rally right here." Saut rightly called the bottom of the summer swoon in August.

Read MoreStocks ready for 'rip your face off' rally

"We think (the market is) getting long in the tooth here," said Emanuel. "What we think is going to happen is the message that the Fed is going to send out tomorrow is going to resonate positively with the investing public."

The Fed's message will be: "The economy is OK ... we're still not going to raise aggressively enough that the economy is threatened in any way shape or form," he said. "We think they're going to do a good job of messaging."

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Squishy economic data, however, have been a concern for the market as manufacturing remains weak and retail sales less than stellar. The economy is growing at a slow pace and the Fed is raising rates at a time when the economy does not seem ready to run much faster than the 2 percent expected for the fourth quarter.

Earnings expectations are also lackluster and have actually been negative for the longest period since 2009. Third-quarter profits for the declined by 0.7 percent and are expected to slide by 0.3 percent in the fourth quarter, according to Thomson Reuters.

For that reason, strategists say a pullback is possible and even if stocks do see new highs next year, the bull market may not run as long as it did in past cycles.

"Usually the first Fed hike of the cycle coincides with some volatility, a midcycle correction, but it doesn't coincide with a major top in the market," Wald said. "It would be consistent to see some weakness in the first quarter. In general, we think the uptrend, the trend in the market in general is going to start to moderate looking out to 2016. You're going to need some period of weakness, more moves sideways for that moderation to be achieved."

Read MoreHere's how the Fed raises interest rates

Wald examined market reactions after the first rate hike, and found that only three times going back to the 1950s was the market negative a year after the first rate rise.

"The Fed tends to hike during healthy periods in the stock market. This is different this time, given we could be going in with some volatility," he said.

"We've broken a four-year uptrend over the summer. the volatility was technically damaging," said Wald, adding a lot of stocks bounced back since.

Jim Paulsen, chief investment strategist at Wells Capital Management, said the Fed doesn't usually hike at this stage in the economic cycle, and its been six years since the recovery began. The central bank took interest rates to zero in 2008, in the thick of the financial crisis.

Markets are also not as welcoming as the Fed might like. "It's scary. The Fed might raise rates with very wide (credit) spreads ... I think it might be (stocks) struggle after that. There's no way we're going to have really rapid growth, so it's almost right at the cusp of being OK to weak," Paulsen said.

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If the market does get a year-end bounce, Emanuel said the leadership will have to expand for it to continue moving higher.

He said he is watching the ISM manufacturing data Jan. 4 and the December employment report, which he believes could set the tone for January's markets.

"If the ISM turns around, we're likely to have a broadening of the market leadership. That's what we need to have happen to keep the rally going. ... We want to be wrong in our belief that the leadership of the market is going to remain narrow," he said. ISM has been under 50, a sign of contraction taken by some to be a recession warning.

"When we look at the first half, if the data falls into place, we think the market could overshoot in the first half. We suggested you could see a trade up to 2,500 in the S&P in the first half. That's counting on the public embracing the message from the Fed," said Emanuel. He also expects a surge in merger activity, as corporate America will rush to get deals approved early in the year, ahead of the presidential election.