The stock market may have priced in Federal Reserve's rate hikes. Here's how to play it

Published Tue, Feb 8 20223:32 PM ESTUpdated Tue, Feb 8 20224:05 PM EST

Patti Domm @in/patti-domm-9224884/@pattidomm

Some strategists believe the stock market has already priced in the Federal Reserve's interest rate hikes for this year, even if volatility remains high. "From where I stand, the Fed has been priced in," said Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets. "Economic damage that could happen from the Fed is not priced in, and it's not clear to me we're going to get that." Wall Street economists expect the Federal Reserve could start raising interest rates in March and boost them possibly four or five more times this year. With rising expectations for higher rates, stocks have sold off and volatility has picked up since the beginning of the year. The central bank is scheduled to have its next meeting on March 15 and 16. Strategists say investors should look to cyclical and value plays that do well in periods of rising inflation and rising interest rates. These would include groups like energy, materials, industrials and financial stocks. Major ETFs represent those market sectors. The Energy Select Sector SPDR Fund is based on the S & P energy sector. The Materials Select Sector SPDR Fund represents the materials sector, and industrials trade as the Industrial Select Sector SPDR Fund . Financials are represented by the Financial Select Sector SPDR Fund . There are also the Invesco KBW Bank ETF and the Invesco KBW Regional Bank ETF . Calvasina said she expects the market made its low Jan. 24, when the S & P 500 fell to 4,222. "We're sort of holding steady in the 4,400ish area," she said. The S & P 500 closed at 4,521 Tuesday. Choppy trading before the Fed's meeting? Of course, there's no guarantee stocks will not head sharply lower again. In fact, strategists say it's quite possible they could retest the lows. But they also see an opportunity for more rotation, rather than downdrafts in the coming weeks, as the central bank's meeting nears. "I do lean toward the view that the market's low is in, but I wouldn't be shocked if we went down and tested that low," said Jim Paulsen, chief investment strategist at the Leuthold Group. "You improved values. You took the concentration of leadership out of the market. You gut-checked sentiment... It did a lot of good things." Paulsen said investors should consider small caps and international, which he says is underappreciated. Many ETFs focus on international markets, including iShares MSCI Emerging Markets Ex China and iShares MSCI Frontier and Select EM ETF . Jefferies equity strategist Steven DeSanctis said the market seems to have found a bottom, but stocks could remain choppy into the Fed's March meeting. Between now and then, earnings season will wind down, and the market will fixate on inflation and other data. Rising bond yields As the Fed meeting approaches, bond yields have been rising. Now, the 10-year Treasury yield is approaching 2% ahead of this week's bond auctions and Thursday's consumer price index report. "I think it goes back to the rotation in the market," said DeSanctis. "A 2% 10-year yield is probably good for financials and banks, perception-wise for cyclicals and not so good for technology and software," said DeSanctis. "I think this is a good thing. We've had the flush," he said. DeSanctis added that the period reminds him of 2016 when the Fed hiked rates. Small caps sold off sharply that year and then came back with solid gains, outperforming large caps. "For me personally, I think the fundamentals are good for small-cap companies. We looked through the earnings season, and clearly no one cares about the earnings season, it's all about the Fed," said DeSanctis, who follows small and mid-cap stocks. "The beats for the fourth-quarter numbers are all good." However, the number of companies beating estimates was better in the second and third quarter. DeSanctis said the market could be making a bottom between now and the Fed meeting. He noted that small caps were down 21% at the trough. "We're not even in a recession. What is it the market is telling you? Down 21% is telling you a lot of bad stuff is priced in. If the consensus holds at five [rate hikes], it's kind of priced in or at least it feels that way," he said. The small cap market still needs to steady, and it would help if ETF outflows would subside, he said. DeSanctis said the iShares Russell 2000 ETF has lost 3.7 % of its asset base this year. "It does seem a little calmer," he said, noting redemptions from active managers seem to have slowed. Names with value-like characteristics As the Fed meeting gets near, markets are likely to stay volatile as investors assess the Fed's rate hiking position. Some strategists say the Fed could find inflation is not as bad as expected later in the year, and that could slow the rate hiking down, a market positive. "I think there's still a lot more volatility on the horizon, and I think it's primarily coming from the readjustment to higher interest rates," said Patrick Palfrey, co-head of quantitative research and senior equity strategist at Credit Suisse. "That's really forcing the markets to take a critical look at value and at growth and really causing the rotation we're seeing in the market. If you think of it from a sector perspective, it's toward cyclicals, energy financials. If you think about it, it's Russell value versus growth," he said. Palfrey said within sectors, stocks with the value-like characteristics will do better. Credit Suisse did a study of stocks that were the sensitive to inflation and found that those that were most sensitive, outperformed others within their sectors since the start of the pandemic. For instance, Diamondback , Devon Energy and Occidental Petroleum were among the most sensitive to inflation in the energy sector. Eaton, Deere and Ingersoll Rand were also listed, as were Parker-Hannifin , Textron and Cummins.

A trader works on the floor of the New York Stock Exchange (NYSE) December 9, 2021.

Brendan McDermid | Reuters

Some strategists believe the stock market has already priced in the Federal Reserve's interest rate hikes for this year, even if volatility remains high.