After years of interest rates that barely rose above 0%, rates jumped in recent months and likely will rise further. This has left many investors scrambling to figure out what to do with stocks because conventional wisdom says higher interest rates tend to kill bull markets. That can be true—but certain types of stocks actually thrive in rising-rate environments. In fact, my research has found that some of the strongest periods of market performance occur when rates are rising in response to economic growth, as they are now, rather than because of soaring inflation. Here’s why—and examples of stocks that could do very well in a rising-rate environment…
WHY HIGHER RATES ARE OK
In October, the yield on 10-year Treasuries, a key benchmark for long-term interest rates, climbed to 3.24%, its highest since 2011, before pulling back somewhat. Fears that a historic era of ultracheap mortgages and other loans was over and that higher rates would dent corporate profits helped set off sharp stock market pullbacks.
But historical data shows that stock investors actually should welcome higher rates now. I’ve analyzed all rolling one-year periods since 1990 in which rates have increased. I calculated the performance of the Standard & Poor’s 500 stock index for each of those periods. What I discovered: When 10-year Treasury yields rose between one-half percentage point and one percentage point in a one-year period, stock market returns averaged 17.9%. When they rose more than one percentage point, returns averaged 12.4%. That makes sense because high yields and the resulting higher interest rates tend to occur when the economy and wage growth are strong and corporate earnings are rising.
Reality check: To benefit from rising rates, stock investors must deal with higher volatility in the market and be willing to buy on pullbacks over the next year. They also must be aware of signs of an impending bear market. If yields rise high enough, consumer and business debt become burdensome…the economy weakens and becomes more vulnerable to other shocks such as a trade war…and the relative safety of bonds makes them look more attractive than stocks to investors. Below are two strategies I’m using now to find stocks with the most potential in this rising-rate environment.
COMPANIES WITH MINIMAL DEBT
I hunt for companies with healthy growth, little or no debt and plenty of cash on hand. These can be found in various areas of the market, the healthcare sector in particular. The more free cash flow that a company has, the greater its ability to stimulate growth (and by extension a higher stock price) by making acquisitions and/or buying back shares and by avoiding the burden of heavy debt repayments. Attractive stocks that meet these criteria now…
Abbott Laboratories (ABT). The health-care products giant has paid a dividend every quarter since 1924 and increased its annual dividend payout for 47 consecutive years. The spin-off of its pharmaceutical division six years ago made it an even stronger, more stable blue-chip stock for investors. Abbott has nearly $8 billion of cash on its balance sheet and reliable cash flow from its specialty nutritional products such as Similac for infants and Ensure for adults, as well as from its diagnostic testing and medical devices. The firm’s new glucose-monitoring system eliminates the need for diabetes patients to stick their fingers routinely to obtain blood. And it sells the
world’s first smartphone-compatible cardiac monitor to help physicians remotely identify cardiac arrhythmias. Abbott took in an estimated $30.5 billion in revenue for 2018, an 11% increase over 2017, and two recent acquisitions will continue to drive future growth. The buyout of St. Jude Medical strengthened Abbott’s cardiovascular product lineup. Abbott’s purchase of Alere makes it a world leader in point-of-care tests, which are carried out at the patient’s bedside and provide results quickly. Recent share price: $72.18.
WellCare Health Plans (WCG) provides managed-care services for 5.5 million Medicare and/or Medicaid recipients in 20 states including the giant markets of California, Florida and Texas. Those government-sponsored health-care programs are expected to grow at annual rates of 7.9% for Medicare and 5.9% for Medicaid through 2023. The company has been using its substantial cash flow to grow quickly through smart acquisitions. Recent examples: WellCare bought health insurer Universal American, which made it the largest Medicaid provider in Michigan and Illinois, and Aetna’s Medicare Part D prescription business. Recent share price: $244.35.
The earnings growth of “cyclical” companies is particularly sensitive to the strength of the overall economy. My research indicates that since 1962, among the sectors of the market that benefited the most from rising interest rates were financials and transportation. Attractive stocks in these sectors now…
Bank of America (BAC). Most large banks can fatten profit margins as interest rates rise because they can quickly hike the rates that they charge on loans while only modestly raising the yields they pay on deposits. But few benefit as much as Bank of America, the second-largest financial institution in the US behind JPMorgan Chase, with more than $1.35 trillion in deposits. It recently estimated that a one-percentage-point rise in short- and long-term interest rates would translate to an additional $2.9 billion in its annual net interest income. The stock is undervalued because investors are wary after years of watching Bank of America struggle to overcome legal and regulatory issues and bad loans tied to the Great Recession. But it’s finally tapping into the potential of its Merrill Lynch brokerage division and is growing earnings faster than many competitors. Recent share price: $24.40.
Union Pacific Corp. (UNP). It may be that no other US industry is so closely tied to the country’s economic ebbs and flows as railroads. Union Pacific’s 23% annualized stock returns over the past three years nearly doubled that of the S&P 500, and the good times aren’t over yet. This 156-year-old behemoth has 32,000 miles of track in the Western two-thirds of the US crisscrossing 23 states from the Pacific to Mississippi. It hauls everything from US military equipment to agricultural goods, lumber and “fracking” sand used in oil and natural-gas production. It would be tremendously difficult for competitors to encroach on Union Pacific’s established territories, and higher oil prices since 2016 give it an advantage over long-haul trucking. Even if the trade war with China heats up further, Union Pacific has such a diverse mix of routes and cargo that its long-term profitability is close to assured. The company has paid a stock dividend without interruption for 119 years. Recent share price: $145.84.