Fed Prepares to Cut Interest Rates — Time to Fear When Others Are Greedy

For most of the past two years, it’s been all systems go for Wall Street bulls. From the beginning of 2023, the iconic Dow Jones Industrial Average (^DJI 0.72%)landmark S&P 500 (^GSPC 0.54%)and stock-fueled growth Nasdaq Composite (^IXIC 0.65%) are up 25%, 47% and 69%, respectively, since the closing bell on September 13, 2024, and all have hit multiple record closing highs this year.

While there’s no doubt that a resilient U.S. economy, along with investor euphoria around artificial intelligence (AI) and stock splits, have driven stocks higher, it’s important to understand that stocks can also do move in both directions.

According to the great investor Warren Buffett, “Be afraid when others are greedy. Be greedy when others are fearful”. The time to be afraid has officially arrived for Wall Street and investors.

Image source: Getty Images.

The Federal Reserve is on track to cut interest rates, and that’s historically bad news for stocks

On the surface, things seem to be going well for the US economy. Gross domestic product is expanding, the unemployment rate is still near historic lows, and the headline inflation rate is inching closer to the Federal Reserve’s long-term target of 2 percent.

But logic doesn’t always play out the way you’d expect on Wall Street.

On the surface, a rising rate environment would be seen as bad for business and growth because it makes borrowing more expensive. Conversely, a rate easing cycle is usually seen as a positive for companies, with lower rates reducing the cost of servicing debt. But if you step back and look at the big picture, you will often find that the reaction of actions is the opposite of this thought process.

The nation’s central bank does not change monetary policy on a whim. It typically does so in response to changes in a multitude of economic data points. When the Fed raised its federal funds rate by 525 basis points beginning in March 2022, it did so to keep the U.S. inflation rate from spiraling out of control while the U.S. economy is firing on all cylinders.

On the other hand, rate easing cycles are often undertaken by the Fed when one or more data points are wrong in the US economy. The Federal Open Market Committee is expected to cut its target federal funds rate when it meets later this week.

Actual Federal Funds Rate Data by YCharts.

Since the beginning of this century, the Federal Reserve has embarked on three rate easing cycles. After the start of each cycle, the Dow, S&P 500 and Nasdaq Composite declined.

• January 3, 2001: Beginning in early 2001, the nation’s central bank began a roughly 11-month easing cycle that moved the federal funds rate from 6.5 percent to 1.75 percent. Unfortunately, stocks didn’t find a bottom during the dot-com bubble until October 9, 2002, some 645 calendar days later.
• September 18, 2007: With the financial crisis taking shape, the Fed began cutting rates on September 18, 2007. Despite cutting the federal funds rate from 5% to a historically low range of 0%-0.25%, the stock market did not drop until 9 March. , 2009, which is 538 calendar days after the first rate cut.
• July 31, 2019: The third cycle of rate easing began shortly before the COVID-19 pandemic took hold. The federal funds rate was quickly cut from a range of 2%-2.25% to, again, a historically low range of 0%-0.25%. A total of 236 calendar days passed from the first rate cut to the lowest market level.

During the rate cut cycles above, the benchmark S&P 500 endured three bear markets that resulted in losses of 49%, 57% and 33% of its value respectively, with the bullish Nasdaq suffering further strong.

Moreover, since the beginning of this century, an average has been taken — I repeat, a average — of 473 calendar days (about 15.5 months) after an initial exchange rate cut for the stock market to bottom out.

Rate hike cycles have a history of preceding recessions

In addition to rate easing cycles that lead to poor results for Wall Street, rate hike cycles typically have anticipated downturns in the US economy.

As you can see in the table below, the nation’s central bank has overseen 13 rate hike cycles over the past 70 years.

Data source: Federal Reserve Board of Governors. Table by author.

The notable data in the table above is that 10 of the previous 12 rate hike cycles were followed by a recession in the US. The only exceptions were two 3.1 percentage point increases in the federal funds rate in 1982-1984 and 1993-1995.

Put another way, any increase of more than 310 basis points in the target federal funds rate by the Fed since 1954 has in the end (keyword!) was followed by a recession. The most recent rate hike cycle saw the nation’s central bank raise rates by 525 basis points.

Although the stock market and the US economy are not linked at the hip, a declining economy has a strong tendency to negatively impact stock valuations. If the unemployment rate rises and economic activity slows, that will ultimately translate into weaker earnings growth, if not a drop in profits, for corporate America.

Historically, about two-thirds of the declines in the S&P 500 since 1929 have occurred during, not before, a U.S. recession.

Image source: Getty Images.

Be afraid when others are greedy, but keep perspective

While nothing is guaranteed on Wall Street, the historical correlation between the stock market and rate hike/rate cut cycles would seem to point to significant downside ahead for stocks. Throw in the fact that the stock market has only been this expensive on two other occasions since January 1871, and you have a strong case that a bear market is in store for you.

While having a healthy cash position ready to take advantage of potential price dislocations can be a smart move, it’s important to maintain perspective if you’re a long-term investor.

For example, as much as working Americans and investors may dislike recessions, they are ultimately a normal and inevitable part of the economic cycle. More importantly, historically, they resolved quickly. Of the 12 recessions since the end of World War II, only three lasted at least 12 months, and none exceeded 18 months.

Comparatively, most economic expansions have lasted several years, with two periods of growth exceeding 10 years. There’s no doubt that optimists have spent far more time in the sun than under gray clouds over the past eight decades.

The same non-linearity to cycles is seen in the stock market.

It’s official. A new bull market is confirmed.

The S&P 500 is now up 20% from its 10/12/22 closing low. In the previous bear market, the index fell 25.4% in 282 days.

Read more at https://t.co/H4p1RcpfIn. pic.twitter.com/tnRz1wdonp

— Bespoke (@bespokeinvest) June 8, 2023

In June 2023, when the S&P 500 was confirmed to be in a new bull market, researchers at Bespoke Investment Group released the dataset you see above on X, the social platform formerly known as Twitter. Bespoke calculated the calendar day length of every bear and bull market in the S&P 500 dating back to the start of the Great Depression in September 1929.

Based on Bespoke’s analysis, the average bear market for the S&P 500 lasted just 286 calendar days, or about 9.5 months, over a 94-year period. On the other hand, the typical S&P 500 bull market lasted 1,011 calendar days, or 3.5 times longer.

You’ll also notice that nearly half (13 of 27) of S&P 500 bull markets lasted longer than the longest bear market, which lasted 630 calendar days from January 11, 1973, to October 3, 1973. 1974.

While history is pretty clear that significant downside is expected for the Dow Jones, S&P 500 and Nasdaq Composite, it’s important to maintain perspective and take a broad-lens approach. Over time, optimism eventually wins out on Wall Street.