The Rate Remedy

By Daniel Kadlec

Here's a quick way to thin the crowd at your next cocktail party: launch into the theory of three steps and a stumble. Those who sense an imminent tale of baby's first steps will flee first. You'll lose the rest when they realize that you're talking about a bear-market harbinger that worked in the '80s. For this is a new age, and if anything is deadlier than a kid story among adults, it's a cautionary tale of how the stock market behaved in the pre-Crash, pre-Internet, it-may-as-well-be-prehistoric era.

Shrinking dividend yields. Soaring price-to-earnings ratios. Bloated book values. Today that's so much hooey. The Dow is about to triple, argues a soon-to-be-released tract for our times--Dow 36,000 by journalist James Glassman and economist Kevin Hassett.

In this new era, "three steps and a stumble" has lost its magic too. Yet the theory deserves comment as an alert to the dangers of rising interest rates. Last week the Federal Reserve bumped its target for the benchmark federal-funds rate to 5.25% from 5%. It was the second such hike this summer, and many believe that the Fed will move again in October. That would fully reclaim the cuts put in place during last year's global crisis and give the Fed more room to cut rates all over again if anything goes wrong at year's end. (Remember Y2K?)

In the old days, three quick Fed rate increases were viewed as evidence of a booming economy and unavoidable inflation--the steps that lead to a stock market stumble. Now, though, Fed hikes don't have that kind of impact because inflation has proved inert for a decade. Even if the Fed raises interest rates a third time this fall, it won't necessarily jolt the market.

What it could do is shift the kinds of stocks and other investments that make the most sense. When interest rates are rising, the last thing you want to own is banks and brokerages, whose cost of money goes up and whose lending and other businesses tend to slow. You also want to avoid highly speculative (read Internet) companies with little or no earnings. Even steady growth stocks like food and beverages tend to lag as their earnings cheapen in an inflationary climate. Fixed-income investors should avoid longer-term securities because prices fall as rates rise, and if you have to sell before a bond matures, you could lose money.

What should you own? If rates keep rising, the rotation into cyclical stocks like Alcoa and Caterpillar that began in April but stalled over the summer could regain momentum. "That play has been shaken but not yet disproved," notes John Manley, market strategist at Salomon Smith Barney. In the fixed-income world, short-term securities are best because they are easily held to maturity and rolled into higher-paying investments.

As with everything on Wall Street, the trick to profiting from any trend is being right about it in the first place. Despite interest rates that are markedly higher today than a year ago, it's not at all clear that rates will keep climbing. In fact, long-term interest rates--set by bond traders, not the Fed--have tumbled in recent weeks on faith that this summer's boosts in short-term rates are enough to stop inflation cold. If that's the case, the logic of the previous two paragraphs applies--in reverse. No one said this is easy. You'd want to avoid T bills and cyclicals and own bonds and growth stocks, including techs and bank stocks too. A good growth-stock fund should cover most of the bases.

And that seems to be the smartest play. Inflation worries have driven growth stocks, including Merck and Philip Morris, 20% lower. Some tech stocks (AT&T) are way cheaper too. Internet stocks, if you're so inclined (I'm not), have fallen even more. Yet the Fed has had the right answer for every new-age inflation scare. Why bet against Alan Greenspan now? It could be that the new era deserves a new truism. Forget stumble. Call it three steps and a start.

See time.com/personal for more on interest rates. E-mail Dan at kadlec@time.com see him on CNNfn Tuesdays at 12:45 p.m. E.T.