Ned Davis Research put out a piece in December 2003 titled “FED WATCH — Much Ado About Nothing or Something?”
I really think the whole thing is much ado about nothing. As shown on table (below), after the Fed has raised rates the first time, the stock market has, on average, risen one month, three months, six months, nine months, and 12 months later, with the 12-month gain actually above the average gain for one-year returns. Moreover, the Fed funds rate at 1% is well below the 6% nominal growth for GDP. Therefore, if the Fed raises rates, they (and Wall Street) can argue that the rate is still very low and stimulating.
NDR’s bigger concern stems from the belief that:
The Fed’s main job is to protect the purchasing power of the U.S. dollar . . . The Fed is actually helping the dollar lose purchasing power both at home and abroad with its easy money stance. I worry that the dollar decline, while bullish if controlled, could turn into a dollar collapse, which could cause foreigners to dump bonds sending bond yields soaring, like they do in every currency crisis.
“Our research shows that the first hike the Fed institutes doesn’t really mean anything. After one single hike, the market typically goes up for the next year. It is really only after a series of hikes that the Fed becomes a negative for the market. Normally, the first hike is seen as the result of stronger earnings, and that offsets any negative interpretation. But lately several Fed governors have said they thought a neutral range for the fed-funds rate [the overnight rate banks charge each other] is somewhere between 3% and 3.5%. We are not talking about a quarter-point hike. Once it looks like they have started down the road, the market is going to make the leap to the 3% to 3.5% range they are talking about. The Fed must hope the economic news is not quite as smoking as it has been so far this month.”
Good stuff. Its supported by other research by James Stack of Investech, who notes:
“Shown in this table are the 10 tightening cycles undertaken by the Federal Reserve over the past 50 years. Along with the date of the first Discount Rate hike is the date at which a resulting bear market (or near-bear market in the case of 1960) began.
Note the following:
• Two of the tightening cycles (1977 and 1994) did not result in a bear market or significantdecline in the S&P 500 Index;
• Another (1958) resulted in a “mild” bear market that began over 15 months after the first rate hike;
• Four others (1955, 1963, 1967, and 1999) resulted in more bull market gains that generally lasted between 7 and 16 months;
• In only two cases -1987 and 1973- did the first rate hike occur prior to the start of the bear market.
So one might say that 80% of the time, the first rate hike did not lead to an immediate bear market. Those are not
bad odds in an election year (which is normally bullish in its own context).
Now let’s look at the associated downside market risk after the first Discount Rate hike. Of those 10 tightening cycles:
• Only one (1987) saw the S&P 500 Index decline over 6% in the 3 months following the first rate hike;
• However, three experienced double-digit losses after 6 months and after 12 months;
• Surprisingly, six out of ten experienced double-digit gains after 12 months. But out of those six, ALL still experienced a subsequent bear market as interest rates kept moving higher.
So while the downside risk of the “first rate hike” cannot be ignored (as evidenced by the 1987 Crash), there’s a dichotomy between expectations and historical reality. Based purely on past precedent, we should still expect higher stock prices over the next 6, and possibly 12, months. This is one reason why our strategy and allocation cannot be determined by monetary policy alone.
Barron’s MONDAY, APRIL 19, 2004
A master technician sees a yellow light flashing