The Fed decision to raise rates yesterday was met with a positive reaction from investors, who drove stock prices up about 1.5 percent during yesterday’s trading session. This reaction can partially be explained by Janet Yellen’s vigorous efforts to allay fears about the reasoning for this first hike, and the pace of the coming series of hikes we should expect. She made a valid point, stating that the Fed is showing strong confidence in the U.S. economy, or they would not have raised rates. However, the simple fact is that the six-and-a-half-year bull market we have experienced has been driven in large part by Fed stimulus (quantitative easing) and historically low interest rates. Keep in mind also that the beginning of this bull market was preceded by a dramatic crash for stocks, driving valuations down well below fair value, even given the weakness in the economy at that time.
Investors were able to set aside the normal stock valuation process in which revenue and earnings growth matter, in favor of a focus on Fed easing and massive stimulus. Unfortunately investors have become far too reliant on the jet stream the Fed has provided, and have lost touch with reality in terms of what true valuations should be for stocks. This situation is over. Regardless of the pace of rate increases, or how many times per year they raise (they are planning 4 raises in 2016), there is no doubt that we are at the very beginning of a multi-year rate raising cycle. Investors can no longer depend on the Fed to bail them out, and will have to instead find stocks that have attractive growth characteristics and appropriate valuations to justify purchases. Those who ignore valuations will do so at their own peril.