What If the Fed Delivers a Surprise Rate Increase?

The stock market continues to climb. The S&P 500 has made up all it lost after the Goldman news, and we’re on our way to the highest close since Lehman Brothers went belly up.
My feeling has been that as long as interest rates are low and profits are growing, then the market will rally. Still, the market is nearing B-Day. This will be the day when Ben Bernanke and the Federal Reserve finally decide to raise interest rates. The futures market currently thinks the Fed will have rates at 0.25% sometime this summer (that’s really not much of an increase since the current range is 0% to 0.25%) and 0.5% by the end of the year.
But what if the Fed decides to surprise everyone by raising rates by 50 basis points or more before? This would be a dramatic move. Gold would plunge and the stock rally might halt in place. The benefit for the Fed is that it’s not much of a move but it would send a strong signal to investors that the economy is getting better and that the central bank is determined to unwind its dramatic policy moves of the past two years.
I doubt a surprise rate hike would have a long-term impact of stock prices, but it would certainly change the tone of the market. A surprise hike is a long shot, but it’s not out of the question. No one can ignore the fact that earnings have been improving quite dramatically. This has been a great earnings season so far. Profits are running 22% ahead of estimates and this is leading analysts to raise their forecasts:

The earnings upgrades come as income beats Wall Street estimates at the fastest rate ever for the third time in four quarters. More than 80 percent of the 173 companies in the S&P 500 that reported results have topped estimates, compared with 79.5 percent in the third quarter and 72.3 percent in the three- month period before that, Bloomberg data show.

It looks very likely that the S&P 500 is on track to earn $80 for 2010 and possibly $95 for 2011. That’s my view but UBS is even more optimistic. They just upgraded their target for the S&P 500 to 1,350. They see EPS coming in at $92 for this year and $100 for 2011. UBS writes: “Moreover, the “junk trade” has re-emerged, with the most economically-sensitive companies and lower quality stocks outpacing the broader market.”
This is exactly what I noted last week.
One final note, Netflix (NFLX) is up another $8 a share today. I think I know how this story ends. I just don’t know when the last act will start.

Posted by on April 26th, 2010 at 11:38 am


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