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What happens to the stock market when interest rates rise?

With the Federal Reserve now widely expected to jack up interest rates in March to beat back rampant inflation, investors in the stock market should buckle up for a more muted few months of returns, says Goldman Sachs chief U.S. equity strategist David Kostin.

The S&P 500 has been "resilient" around the start of Fed hiking cycles in the past, Kostin notes. But one could interpret that resiliency Kostin speaks of in different ways.

The first is that the stock market didn't fall off a cliff as borrowing conditions became tighter, but losses did come to market goers. The S&P 500 has dropped 6% on average during the three months following the first rate increase of recent cycles, Kostin finds.

On the other hand, the weakness in stocks has proven short-lived. The Goldman strategist finds the S&P 500 has returned 5% in the six months following the first rate hike of a cycle.

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Either way you look at it, the evolving backdrop requires a careful recalibration of one's approach to investing. That may be especially so at the start of this cycle, as Goldman Sachs is looking for 10 interest rate increases before 2025. JPMorgan CEO Jamie Dimon didn't rule out seven interest rate increases this year in his typical free-wheeling earnings call with analysts.

Stock market: Not all sectors win during interest rate hiking cycles, Goldman Sachs cautions.
Not all sectors win during interest rate hiking cycles, Goldman Sachs cautions. (Goldman Sachs)

"The start of Fed hiking cycles tends to coincide with a strong economy, which can help to lift cyclical sectors (materials, industrials, energy). At the factor level, value stocks tend to outperform in the months before and after the first hike. High quality factors (e.g., high margins, strong balance sheets) underperform in the strong economic environment preceding hikes and outperform in the months following the initial rate increase. Growth is the worst performing factor in the six months around the first hike," explains Kostin.

To be sure, the stock market is behaving in line with Kostin's work on returns and Fed hiking cycles.

The S&P 500 is down 2.79% in 2022 so far, while the Dow Jones Industrial Average has lost 1.84%. The Nasdaq Composite has shed a whopping 5.93% year-to-date. More than one-third of companies in the index are at least 50% from their 52-week highs, according to Bloomberg data. High multiple tech stocks continue to be under severe pressure, notably fintech player Block (formerly Square), which is hovering around a 52-week low.

"We are in this adjustment process, which might be a little patchy. We are adjusting from an economy that was very strong and the Fed was doing nothing. This is clearly changing," said iCapital chief investment strategist Anastasia Amoroso on Yahoo Finance Live. "We are seeing this stepped down lowering of activity — still solid but slower. But now the Fed is starting to do something about it. That's what is causing some volatility here. This might be a process that goes on for some time.

Brian Sozzi is an editor-at-large and anchor at Yahoo Finance. Follow Sozzi on Twitter @BrianSozzi and on LinkedIn.

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