Markets Are Pricing in a Fed Rate Hike in December. Here's What Investors Should Do, According to History.

Kevin Warsh has already presided over one Federal Reserve rate hike during his first few months as Fed chair. And now another rate increase could be on the way.

The Federal Open Market Committee (FOMC) voted to leave the federal funds rate unchanged at its October meeting. However, CME Group‘s (CME -0.44%) FedWatch projects an 81.2% probability of a rate hike at the committee’s December 2026 meeting.

This likelihood of a second rate increase raises a key question for investors: What should I do? History has four good answers to that question.

1. Don’t blindly sell stocks

Investors could be tempted to run for the hills and sell all or most of their stocks. History shows that’s a really bad move.

The S&P 500 (^GSPC +0.31%) has risen by an average of around 9% over the 12 months following a new rate-hike cycle, according to research conducted by Goldman Sachs (GS -0.36%). Granted, the index initially declined by roughly 2% on average during the first three months after the first rate increase of a cycle. But selling stocks en masse early in a rate-hike cycle would have usually cost investors in the past.

2. Focus on the most promising sectors

Some stocks outperform others in environments with rising interest rates. History shows that focusing on the most promising sectors can pay off.

For example, energy stocks were the clear winner during the Fed’s last major series of rate hikes from March 2022 through July 2023. The State Street Energy Select SPDR ETF (XLE -0.02%), which owns shares of 21 energy sector leaders, jumped around 18% during the period. Oil and gas giant ExxonMobil (XOM +0.34%) and pipeline stock Energy Transfer LP (ET -1.41%) delivered even higher returns.

3. Reduce bond durations

For investors who own bonds, shifting from long-duration to short-duration bonds is practically a no-brainer. When interest rates rise, bond prices tend to fall. Longer-duration bonds get hit the hardest. The good news is that you can buy a short-term U.S. Treasury bond that’s essentially risk-free and get a yield north of 4% right now.

4. Read between the lines with the Fed’s actions

As important as the FOMC vote in December is, it’s even more important for investors to read between the lines with the Fed’s actions. The trick to doing this is to analyze the updated dot-plot projection, a chart that shows how individual FOMC participants expect short-term interest rates to move.

In particular, pay attention to how aggressively policymakers expect rates to increase. Goldman Sachs’ research found that especially rapid rate hikes have led to worse stock market performance in the past.