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The prevailing assumption is that when the Fed does wrap things up stock prices will rally, even though this view is not supported by history. An analysis of the 14 Fed tightening cycles that have occurred since 1929 indicates that in the majority of cases (10 out of 14), stock prices were lower six months after the final Fed rate hike.

The most optimistic analysts seem to be anticipating a replay of the strong rally that followed the 1994-1995 tightening cycle, when the S&P 500 surged 18.8% and 35.7%, respectively, in the six and twelve months following the final Fed rate hike. Unfortunately, we find few parallels between the current environment and the one that prevailed in 1995.

First, stock market valuations in early 1995 were about two-thirds as high as they are today. Second, the economy in 1995 was not burdened by today’s debt levels and inflated real estate values, both of which are likely to be a drag on economic growth for several years to come. Third, when the Fed finished tightening in early 1995, the 10-year Treasury yield was 7.8% (versus 5% today), providing ample scope for long-term rates to decline and support the economy and the stock market.

In addition, the recent rise in interest rates puts additional pressure on the housing market, where recent trends in inventory levels, sales activity, and mortgage applications were already pointing to a softening of prices. Thus far, there has been only anecdotal evidence of a leveling off of housing prices. Indeed, according to the most recent report from the National Association of Realtors, the national median existing-home price in February was up 10.6 percent on a year-over-year basis.

The consensus outlook for housing is a benign transition to more “normal” levels of appreciation and sales activity. This view is expressed by the National Association of Realtors and Freddie Mac, both of which are estimating housing appreciation of 6-7% this year based on moderately higher interest rates and a continued strong employment market. Although the jobs market has provided an important support to housing in a rising interest rate environment, we disagree with those who say don’t worry about rising interest rates because the economy is good and incomes are rising. What we have seen in the housing market in the past several years has been anything but normal, so it is unlikely that the adjustment process will be normal. What has driven the housing boom is the unusual condition of home price appreciation running well above mortgage rates for a sustained period of time.

Historically, it is rare for the rate of appreciation in the median home price to exceed the long term mortgage rate, but in this cycle appreciation rates have exceeded borrowing costs for the past five years and last year reached a record spread of 8% when year-over-year median home price appreciation peaked at 14% with 30-year mortgage rates at 6%. This dynamic predictably drew speculators and second home buyers into the market; the National Association of Realtors recently estimated that a record 40% of homes bought in 2005 were for investment purposes or vacation (second) homes. That demand is likely to diminish significantly as the relationship between home price gains and borrowing costs corrects.

Source: End of the Fed's Tightening Cycle May Bring Drop in Stock and Housing Prices