What to Buy as Fed Begins 'Normalization Process'

The Federal Reserve went out of its way Thursday to signal that its hiking of the discount rate is not a sea change, but just a gentle tweak of its policies, saying “the modifications are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy.”

But the stock market, being that discounting mechanism that it is, is not going to take this lightly, but instead treat this as a starting pistol to a difficult period of the removal of easy money for the markets, culminating in a hike of the Fed Funds rate.

“While we agree that it won’t significantly impact the cost of funds, it is an incremental step in the normalization process,” wrote Barry Knapp, Barclays Capital Equity Strategist in a prescient note to clients at the end of last week. “We think ’10 will follow a pattern quite similar to ’04, when stocks spent the first half of the year anticipating the end of the easiest monetary policy in decades. We believe that by the time the Fed actually raises rates, the market adjustment will largely be complete and equities will post positive returns in second half 2010.”

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Knapp is telling clients to position themselves away from cyclicals and into to defensive sectors with lower valuations. With interest rates now on the rise, the overall price-earnings ratio for the market is likely to contract, favoring the sectors with already low valuations.

Knapp is getting out of materials, energy and financials and rotating into health care, staples and telecom which “almost all appear uniformly cheap.”

Investors are already pushing into those sectors with the Consumer Staples SPDR and the Health Care SPDR up for the year.
Within staples specifically, Procter & Gamble is among the top performers, sporting a 15.1 P/E ratio, below the 15.8 average for household products companies and the 18.3 mean multiple for the broader consumer goods sector. Kraft, a favorite of Pershing Square’s Bill Ackman, is also an outperformer this year in that group.

One sector typically thought of as “defensive” could get its lights knocked out during this “normalization process.” Utilities, owned often for their high dividend yields, could fall as higher interest rates make bonds a more attractive alternative than their payouts.

Proving the stock market is already anticipating this move — no matter how hard the Fed tries to play down this change — utilities are the worst performing sector in the market for 2010, with the Utilities SPDR (XLU) already down more than 5 percent.

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