Buyer Beware: Historical Patterns of Federal Reserve Rate Easing Often Signal Looming Dangers for Wall Street.
With merely six trading days left in the year, the esteemed Wall Street is poised to conclude a remarkable run. As indicated by the final bell on December 18, the mature-stock-led Dow Jones Industrial Average (-0.59%), comprehensive S&P 500 (-0.73%), and innovation-driven Nasdaq Composite (-0.83%) have shown impressive gains of 12%, 23%, and 29% respectively.
The stock market's triumphant year can be credited to a multitude of factors that include:
- The burgeoning appeal of artificial intelligence (AI), boasting an addressable market of $15.7 trillion as per PwC's research.
- The heated anticipation surrounding stock splits in some of the influential companies in Wall Street.
- Superior than anticipated corporate earnings.
- The victory of President-elect Donald Trump. The Dow Jones, S&P 500, and Nasdaq Composite surged during his first term in office.
However, ominous indications are proliferating, suggesting that the stocks may have ascended too swiftly. For instance, the S&P 500's Shiller price-to-earnings (P/E) ratio now stands at its third-highest valuation in 153 years.
Potentially less discernible correlative events, such as Federal Reserve rate-easing cycles, have served as a foreboding warning signal to investors throughout the 21st century.
Caution, investors?
The Federal Reserve is accountable for spurring economic growth while maintaining a steady course against uncontrolled inflation. To accomplish this balance, it modifies monetary policy as required. These modifications might involve adjusting the key federal funds rate, along with open-market operations, involving the purchase or sale of long-term Treasury bonds to alter yields. While this might sound monotonous, it's intriguing to note that stocks have traditionally reacted in an unconventional manner to the Fed's monetary policy actions.
For instance, if the Fed raises interest rates and makes borrowing more expensive for businesses, the logical corollary is that corporate growth would slow down with limited financing. Yet, the stock market's most significant gains in the 21st century have occurred during rate-hiking cycles when the Fed attempts to control inflation.
Conversely, lowering interest rates would theoretically be advantageous since it reduces borrowing costs and encourages lending. However, history has shown that rate-easing cycles are not always as beneficial as they seem.
The central bank does not capriciously alter monetary policy. It usually responds to a multitude of economic data points. If the Fed reduces the federal funds rate, it typically signals concerns about economic weakness or the risk of deflation.
Rate-easing cycles have been correlated with substantial declines in the stock market
Since the turn of the century, the Federal Reserve has initiated four rate-easing cycles, including the one currently in progress. All three prior cycles have been associated with substantial declines in Wall Street's benchmark index, the S&P 500.
The initial transition to a dovish monetary policy officially occurred on January 3, 2001. Over the course of approximately 11 months, the nation's central bank lowered its federal funds rate from 6.5% to 1.75%. However, as depicted in the chart below, the S&P 500 took 645 calendar days after this initial rate reduction to find its lowest point. In total, the S&P 500 suffered a loss of over 42% of its value post this initial cut.
The Federal Reserve initiated its second round of rate cuts just before the financial crisis started taking shape on September 18, 2007. Given the unprecedented nature of this crisis, it's hardly surprising that the Fed reacted with an extraordinary measure. Over a span of 15 months, the federal funds rate was lowered from 5% to a historically low range of 0% to 0.25%.
However, as you'll observe in the following chart, the S&P 500 took 538 calendar days after this initial reduction in September 2007 to reach its nadir in March 2009. It plummeted by over 55%, with the growth-focused Nasdaq Composite suffering even greater losses.
The third rate-easing cycle undertaken by the Fed commenced at the end of July 2019. Due to the COVID-19 pandemic taking shape, it took less than eight months to lower the federal funds rate from a range of 2.25% to 2.5% back to 0% to 0.25%.
As shown below, the benchmark S&P 500 shed nearly 25% of its value over 236 calendar days following this initial rate reduction.
It's important to note that recessions often emerged shortly after the three previous rate-easing cycles. Though a recession does not ensure that stocks will decline, approximately two-thirds of the S&P 500's peak-to-trough drawdowns since 1927 have occurred during, not prior to, a recession being declared, based on data from Bank of America Global Research.
In summary, rate-easing cycles have historically been detrimental to the stock market in the 21st century. However, there is a silver lining as well.
While the recurring theme in history on Wall Street might seem daunting, it actually benefits long-term investors, given the connection between ease in interest rates and significant drops in indices like the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite.
The unavoidable truth is that the US economy will inevitably experience contractions occasionally. Similarly, stock market corrections and bear markets are not uncommon occurrences. However, it's crucial to understand that economic and investing cycles aren't straight lines.
Since World War II concluded in September 1945, the U.S. economy has survived 12 economic downturns. Interestingly, nine of these downturns concluded within 12 months, and none exceeded 18 months.
Concurrently, numerous economic expansions have persisted for multiple years, including two periods exceeding the 10-year mark, despite the inevitable occurrence of recessions. Regrettably, these recessions never extensively impede long-term growth rates.
This trend is also visible in the comparison of bear and bull markets on Wall Street.
Indeed, a new bull market has begun. The S&P 500 has surpassed its 10/12/22 low by 20%, confirming the new market rise. Previously, the index experienced a 25.4% decline over 282 days during the bear market. You can read more about this at this link. Here's the associated image
-- @bespokeinvest on June 8, 2023
In June 2023, following the confirmation of a new bull market by Bespoke Investment Group, they shared the following data set on social media platform X. The data reveals the calendar days of every bear and bull market in the S&P 500, starting from the peak of the Great Depression in 1929.
Over this 94-year period, there were 27 S&P 500 bear markets, with the average downturn lasting only 286 calendar days (around 9.5 months), and the longest bear market on record lasting 630 calendar days.
However, a typical S&P 500 bull market averages 1,011 calendar days, which is about 3.5 times longer than the average bear market. If the trends continue, 14 out of 27 S&P 500 bull markets have outlived the lengthiest bear market.
Even if history repeats itself and the stock market experiences another downturn due to the introduction of the latest rate-easing cycle, patience and a broader perspective will still prove profitable for investors.
Investors may want to consider the impact of the Federal Reserve's monetary policy on their investments, as rate-easing cycles, while historically correlated with substantial declines in the stock market, can also provide opportunities for long-term gains. Despite the 21st century seeing significant losses during rate-easing periods in the S&P 500, these periods have often been short-lived, with bull markets typically lasting much longer.
Given the average bear market lasts only 286 calendar days, compared to the average bull market's 1,011 days, investors might find it beneficial to maintain a long-term perspective during periods of market volatility caused by rate-easing cycles.
