The Best Stocks to Buy in a Rate Hike Cycle

Let me let you in on a little investing secret: Rate hikes are actually great for growth stocks.

I know. It sounds completely counterintuitive. Your finance 101 class taught you that the value of a stock is equal to the net present value of a company’s future cash flows into perpetuity. That net present value utilizes a discount rate, which — per the widely recognized Capital Asset Pricing Model — is influenced by the target established by the Federal Open Market Committee’s (FOMC) federal funds rate.

The higher that interest rate, the higher the discount rate used in valuation models, and the lower the value of a growth stock today.

Simple enough, right? Indeed, all year long, growth stocks have been getting crushed on Wall Street for fear that the Fed will start hiking interest rates next year to combat inflation, which will weigh heavily on growth stock valuations.

But what if I told you that growth stocks historically thrive in rate-hike cycles?

Let’s look at the data.

The last time the Fed entered into a steady rate-hike cycle was in December 2016. Over the subsequent two years, the Fed hiked rates about eight times. During that time, growth stocks thrived. Cathie Wood’s flagship ARK Innovation ETF (NYSEARCA:ARKK) — which represents a collection of the highest growth stocks in the market — soared 90% from December 2016 to December 2018.

In other words, the last time we were in a rate-hike cycle, growth stocks outperformed the market by 10X over two years. By comparison, the S&P 500 rose just 9% over that same stretch.

That’s an insane outperformance. So much for the old idea that rate hikes are bad for growth stocks…

The reality is that the FEAR of rate hikes is bad for growth stocks, but rate hikes themselves are actually good for growth stocks.

Here’s why.

In anticipation of rate hikes, everyone refers to their finance 101 book, and freaks out that higher rates are going to suppress growth stock valuations, so they sell growth stocks. This happened in 2016. In anticipation of the Fed entering a rate hike cycle, growth stocks struggled.

But once those rate hikes materialize, investors check their math and realize that gradual 25-basis-point increases in the Fed funds target rate don’t actually impact valuations all that much. Meanwhile, the fact that the Fed is hiking rates means the economy is doing well, which should mean that growth companies are growing their sales and earnings more quickly.

Net net, when it comes to growth stocks during rate-hike cycles, faster sales and earnings growth more than offsets minor valuation compression, and they end up powering higher.

Again, see the last rate hike cycle from late 2016 to late 2018. Growth stocks outperformed the market by 10X!

But they underperformed heading into that rate-hike cycle.

We’re seeing the same story play out right before our very eyes.

Growth stocks have underperformed meaningfully in 2021 ahead of what many are expecting to be a new rate hike cycle starting in 2022. But history says that once that rate-hike cycle does get started, growth stocks will shake out of this slump and power higher – way, way higher.

So, despite everyone telling you that growth stocks should struggle in 2022 amid a rate-hike cycle, the best thing you can do right now is to actually buy growth stocks.

They’re due for a huge 2022.

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