By Lee Levy

The Federal Reserve (FED) Bank’s unprecedented stimulus program is ending in October, and investment experts – and the Fed itself – believe rate increases will be the next step in the quest to normalize monetary policy.

In fact, in an official report released in mid-September, 14 of 17 Fed officials believe the central bank’s first increase in interest rates as early as the first quarter of 2015.

With that as a backdrop, what should investors do strategy-wise to take advantage of this change?

According to Lee Levy, founder and General Partner at Canid Asset Management LLC, a Silicon Valley-based boutique asset management multi-strategy mid-to-large cap liquid long/short equity hedge fund, among other things investors should make the expected market volatility work for them.

Levy explains that a steady transition to higher rates will be positive for stocks due to improving economic growth, moderate inflation, better relative valuations vs. bonds and increasing investment in equities.  Yet, at the same time, he believes the Fed’s policy shift will boost market volatility.

“We see rising volatility as an opportunity,” he explains. “That is, if you have access to a complete set of investment tools for generating return and reducing risk in different market environments.”

Building A Solid Strategy For 2015 Fed Rate Hikes

Why Fed’s rate hike will benefit stocks?

Levy says he firmly believes that the Fed’s rate increases will be good for stocks for multiple reasons:

  • The Fed has shown every indication that rate increases are likely to be moderate with relatively transparent reasoning. In essence, the Fed will seek a smooth transition toward higher interest rates.
  • Moderately higher interest rates should be good for stocks over the intermediate-term horizon. After all, the Fed raises rates when the economy and businesses are healthy and prosperous to cool down an economy that might overheat.
  • Higher interest rates curb inflation, the bane of all financial assets. Higher interest rates should also make stocks more attractive relative to bonds.
  • Investors are likely to sell bonds and buy stocks in response to rising interest rates.

“The shift from bonds to stocks requires some explanation,” Levy adds, adding that the Fed has been a large buyer of U.S. Treasuries for a couple of years, which kept interest rates hovering near all-time lows. “In some months, the Fed bought a whopping 90% of newly issued government debt.”

Levy explains that when the Fed is no longer buying long-dated Treasuries, interest rates should rise (and bond prices should fall) due to lower demand. The money, which previously flowed into bonds due to the Fed’s rate cuts and bond purchases, will flow into stocks.

“Unfortunately, investors seeking safety have piled into bonds over the last several years, leaving them under-allocated to stocks in some cases,” he notes.

When interest rates rise (and bond prices fall), many of those investors are likely to become uncomfortable with bond losses and look to stocks. Similarly, large pensions and institutional investors have enjoyed incredibly strong returns from their bond portfolios for the last 20-30 years. They will see those gains reversed for the first time in a generation. The asset allocation landscape will look radically different than the last 30 years, and many managers might not be prepared for this change.

Today’s Fed rates within one percent of all-time lows

Levy goes on to say that today, rates are within one percent of all-time lows. Bond returns for long-term investors are almost entirely dependent on a bond’s yield (the prevailing interest rate). All-time low rates means all-time low expected returns for most of the bond market. As a result, Canid is expecting stocks to benefit from reallocation shift from bonds to stocks, as a wide range of investors reassess the role of bonds in their portfolios.

“Although higher rates should be good for stocks, increasing market volatility is a near certainty, as the Fed has been a strong positive influence on all financial assets since the crisis in 2008,” Levy says. “Investors will have to adjust to the Fed’s change in direction, which should increase volatility.”

And that’s where seeing volatility as an opportunity takes center stage. For example, Canid Asset Management’s portfolio structure of longs, shorts and options give it the ability to adjust its risk/return profile.

“That gives us the ability to zig when the market zags,” Levy says. It also means Canid can capitalize on sell-offs by finding good companies selling at a discount or increasing market exposure when the market overreacts to bad news. For example, investors were worried about rate hikes in August, so Canid ramped up its long exposure, primarily via long calls, which led to its best month of the year.”

Over the last few years, the nation has seen a situation where money is cheap to borrow but banks have not wanted to lend money. While that is changing (banks are lending again), the dilemma for investors is bond prices are high and interest rates are low, so where do they put their money?

“When the market was down and very cheap everybody was afraid to buy because they thought it was going lower,” Levy says. “It’s human nature to wait till the coast is clear to start buying.”

Lee adds that “buy low, sell high” is the first thing investors learn, but this approach hurts them in a bull market because in a bull market, you have to buy high.

“You have to allow your money to work for you. Don’t try to time the market, it’s too hard for most people to do,” he says. “The best thing is to leave it to the professionals.”

About Canid Asset Management LLC

Canid Asset Management LLC is a Silicon Valley-based boutique value hedge fund offering a broad range of wealth management solutions. Launched in 2009, Canid is a young fund that successfully manages a liquid long/short equity portfolio specializing in protecting investor capital during highly volatile markets using quantitative, fundamental & tactical investment approaches hedged with sophisticated option strategies. The firm posted 2013 returns 2000 bps greater than Hedge Fund Indices. In addition to the Fund, Canid Asset Management also manages separate accounts. For more information, please visit www.canidasset.com or contact Lee Levy at [email protected].