Rate discounts and historical market analogs

Studying market history has made me a better investor.

Calculating historical performance data is one of my favorite moves for this blog. It helps provide some insight into the potential risks and range of outcomes in the markets.

Market history also helps keep you grounded.

It is important to understand bursts and bursts—the South Sea Bubble, the Panic of 1907, the Roaring Twenties, the Great Depression, the Fifty Fifty, the Great Inflation of the 1970s, the Crash of 1987, the Japanese asset bubble of the 1980s, the boom and bust dot-com, the Great Financial Crisis and more.

These periods help define the human condition – from fear to greed, panic to euphoria, jealousy to fear of loss, and more.

But market history requires context and perspective. It can help you prepare, but it’s not a surefire way to predict what’s coming.

As Warren Buffett once wrote, “If past history were all that was needed to play the money game, the richest people would be librarians.”

For example, thinking about the current economic regime has been difficult for both investors and pundits.

In 2022, everyone assumed a recession was a foregone conclusion based on historical analogs (inverted yield curve, high inflation, etc.). It didn’t happen.

Now inflation appears to be under control and the Fed is cutting rates with the stock market to historic highs.

And apparently that means either the coast is clear or we’re on the verge of collapse.

It’s hard to believe, but I’ve been in this situation before (sort of).

We had our research team look at the 12-month forward returns from every initial Fed rate cut since 1957:

You can also see a breakdown of whether or not that initial rate cut occurred when the market was within 5% of all-time highs.

One-year returns after the Fed’s first rate cut have been pretty good.

Average returns are, well, average. And five out of seven times when the Fed started cutting rates near historic highs, the market was higher 12 months later.

Here’s the same breakdown showing three-year forward returns:

Again, pretty good. Six out of seven times the stock was higher 36 months later when the market was near all-time highs.

This is good news for investors. Most of the time, things have gone well when the Fed cuts rates near historic highs.

This makes sense and is intuitive. Easier monetary policy should be good for corporations.

However, I also want to offer some caution when considering what’s coming in the current release. I have never seen anything like the current environment.

Here is an incomplete list of what makes this situation unique:

• We are still recovering from the pandemic.
• It was thousands of billions of dollars in government spending.
• The stock market has been in a market for about 15 years.
• Interest rates were all over the map.
• The US has experienced only two months of recession since June 2009.

In addition, there is the fact that the Federal Reserve has never been more transparent than it is today. Investors in the past had to guess what the Fed was thinking. Now, they won’t shut up about it.

The truth is, I don’t know.

It’s helpful to know that Fed interest rate cuts to and around historic highs haven’t caused disaster in the past.

But it’s also true that the stock market has risen most times over most 12- and 36-month periods historically.

History is helpful to a point, but things that never happened before seem to happen all the time these days.

Human nature is the constant in all market and economic cycles, but people are very unpredictable.

Because of this, the markets are also unpredictable.

Further reading:
The stock market never changes