Malcolm Graham
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How to make money from the Fed’s interest-rate decision

Investors will overshoot in either direction, enabling you to make a quick buck

Federal Reserve/Flickr

Federal Reserve Chairwoman Janet Yellen

(MarketWatch) — Making money from the Fed’s interest-rate meeting this week should be easy: Just do the opposite of what most investors do immediately after the decision is announced.

I say this because the timing of when the Federal Reserve decides to raise rates makes no significant difference in the real world. So we can be assured that the market’s immediate reaction to that decision, whatever it may be, will soon be corrected.

For example, if the Fed decides to begin raising rates right away and the market plummets, as it very well could, then you should bet on a quick recovery. By the same token, if the Fed decides to postpone a rate hike and the market soars, you should bet on a quick retreat.

I readily concede that you would never guess that the Fed’s rate-hike decision is so meaningless, given Wall Street’s and the media’s hysterical obsession with it. But when I asked a number of economists why the timing of the rate increase really matters, none could come up with a plausible story.

On the contrary, they told me, the stock market’s fair value will be nearly the same regardless of whether the rate increase comes this week, or in December, or sometime next year or even thereafter.

This isn’t to say that rates don’t matter. But unless you believe short-term rates will permanently stay as low as they are now, or you believe rates will jump by orders of magnitude more than what anyone is contemplating, then the timing of their increase makes surprisingly little difference.

Consider the three major ways in which a rate increase might otherwise be expected to affect the stock market and why their potential impact in the current situation is small.

The present-value argument

When interest rates are higher, the present value of a company’s future earnings and dividends will be correspondingly lower. But, as a practical matter, the reduction is minor.

I won’t bore you with the math, though feel free to use your spreadsheet program to calculate the present value of a company’s earnings or dividends over the next decade under various assumptions. Consider two extremes — on the one hand, an assumption of no rate increase over the next decade, and on the other hand, an immediate increase of 25 basis points.

The present-value difference of these two extremes is just 1.1%. And note carefully that I constructed this illustration to maximize this difference. Few seriously entertain the possibility of permanently low interest rates.

The real-world impact of a rate hike becomes smaller and smaller as these hypothetical extremes are eased. The difference shrinks to almost nothing when you contrast the present-value impact of a difference of just three months when a 25-basis-point increase takes place.