Top Two ETFs for When Interest Rates Increase, Investor Sentiment Plummets

This past weekend, a friend of mine made a statement that there must be a large amount of economic growth coming shortly because of the booming stock market, driven by investor sentiment.

As I told him, the two are not necessarily tied together.

Over the past few months, we have heard about how economic growth is about to accelerate here in America, and this has helped drive investor sentiment in the stock market higher. However, I think there are many questions that need to be answered before we can assume economic growth will reach escape velocity, and investor sentiment is heavily contaminated with a large addiction to monetary policy.

Also Read: NYSE holidays 2014

Some of the data has improved; however, many other reports only lead to murkier water.

For example, we all know that economic growth requires the consumer to be active, since consumption is approximately 3/4 of the U.S. economy. But for the holiday season, many retail companies issued disappointing results, even though there were signs that consumer spending was beginning to pick up. This is an interesting data point: during the fourth quarter of 2013, consumer debt increased by $241 billion from the third quarter, the biggest jump in debt since 2007. (Source: “Quarterly report on household debt and credit,” Federal Reserve Bank of New York web site, last accessed February 19, 2014.)

Should investor sentiment view this increase in consumer debt as a positive or negative for economic growth?

A large amount of the debt increase came from the automobile industry, but what really worries me that could impact future economic growth is the combination of higher debt with weaker retail sales and inventory levels that continue to build up.

What this tells me is that businesses were too optimistic about the level of economic growth, since even though consumers ramped up spending, it wasn’t enough to buy all of the goods now sitting as inventory. Unless consumption ramps up, economic growth will slow, as there is a lower level of demand for manufacturing over the next few quarters. Essentially, economic growth was pulled forward.

Personally, I think investor sentiment will continue to look past many data points on economic growth and focus solely on the Federal Reserve. As long as the central bank is pumping money, investor sentiment will remain bullish.

However, what happens later this year when economic growth is tepid, yet not weak enough to alter the Federal Reserve’s stated goal of reducing monetary policy?

Investor sentiment could be setting up for a double whammy—the Federal Reserve that is on the margin of pulling back on monetary stimulus, and economic growth that is not strong, but not weak either. In this scenario, companies will begin to feel the squeeze, resulting in a decrease in profit margins.

We are already seeing companies reporting a deceleration in earnings growth over the past four quarters. As economic growth is cyclical, investor sentiment could be severely impacted, especially as the market begins to price in higher interest rates.

As long as the market believes that the Federal Reserve will continue to keep interest rates low, investor sentiment will remain bullish. But as soon as there are indications that the Federal Reserve will move beyond reducing asset purchases and actually increasing interest rates, investor sentiment will be hit hard.

There are several things you can do to help adjust your portfolio. One is to add a hedge that goes up if the market moves down, such as the ProShares UltraShort S&P500 (NYSEArca/SDS), although this exchange-traded fund (ETF) works better over a shorter time period. Another method would be to add stocks that aren’t as economically sensitive, such as the SPDR S&P Biotech ETF XBI. With new innovative medicine being developed that isn’t based on the overall economy, as well as the potential for buyout activity, I think biotech stocks will continue to do well this year.

This article Top Two ETFs for When Interest Rates Increase, Investor Sentiment Plummets was originally published at Daily Gains Letter