Interest rate hikes by the Fed won't end the bull market in stocks — but a 10% sell-off is likely, Fundstrat says

• Interest rate hikes by the Federal Reserve don't end bull markets, according to Fundstrat.
• But a 10% sell-off in the stock market is likely as the Fed prepares for its first increase since 2018.
• "Rate hikes don't end the bull market, but the market generally pauses around the first hike," Fundstrat's Tom Lee said.
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Expected interest rate hikes by the Federal Reserve later this year won't end the bull market in stocks, according to a Tuesday note from Fundstrat's Tom Lee.

Instead, investors should expect a 10% sell-off in the stock market as the Fed makes its first increase since 2018. Lee's conclusion is based on an analysis of stock market performance every time the Fed began to raise interest rates since 1990.

"What is apparent... is that Fed raising rates does not spell the end of a bull market," Lee said. Instead, stocks go on to generate significant returns after the Fed's first rate hike of a tightening cycle, and economic recessions remain well in the distance.

This finding is backed up by separate research from LPL's Ryan Detrick, who tracked stock market performance amid a 100-basis-point rise in the US 10-Year Treasury yield. Based on 14 instances since 1962, his analysis showed stocks return an average 17.3% with a winning percentage of 79% when the yield rises.

"Historically a higher trending 10-year yield has been really good for stocks. The past seven periods of higher yields all saw higher stocks, with some huge gains in there," Detrick said.

But the transition from an easing Fed to a tightening Fed does build up anxiousness among investors, and the policy transition leads to volatility in the market.

Since 1990, each of the four prior "first hikes" by the Fed led to at least a 10% sell-off in stocks, according to Fundstrat. The worst was in 2016 when the S&P 500 fell 15% after the Fed hiked rates.

"Very likely equities do this because markets are adjusting to a shift in market perception of liquidity, and a shift in perception around Fed policy," Lee explained.

With the bond market pricing in the first Fed rate hike this March, investors could be selling stocks to de-leverage in anticipation of the decline, contributing to the recent 5% drop in the S&P 500 and 8% decline in the Nasdaq 100.

But Lee thinks the S&P 500 can resume its climb to a record 5,000 before the Fed's first potential rate hike this March, according to the note.