SHOULD INVESTORS FEAR A FED TIGHTENING? Pretty important question at this time if there is one. In his August 14 “Breakfast with Dave”, David Rosenberg, one of the better and most influential economists, flatly says that the answer is no.
In actuality, we went back to history books and found that in the first 25% of the Fed rate-increasing cycle – whether it be in terms of magnitude of rate hikes or length of the cycle – and found that the S&P 500 was consistently up, not down, in this initial stage (…).
Using duration of the tightening cycle or “time” as the benchmark (i.e. splitting up the various phases by 25% increments), the S&P 500 was up an average 3.6% (median +2.4%); using “duration” or basis-point change as the benchmark, the first 25% of the cycle sees an average gain of 7.2% (median of +5.6%).
In fact, (…) the first 25% of the tightening cycle is typically the best part of the stock market cycle because the Fed is only lifting rates because it has gained confidence that the economy is taking off, and at this point of the tightening cycle the Fed has usually not even adjusted to a neutral (let alone a tight) policy stance.
David had written about that in a March Financial Post article which made me react in THE FIRST RATE HIKE: THE WAKE-UP CALL in which I disputed his findings looking at the history since 1975.
Being but a curious and doubting slob, this time I took the time to look at each of the 15 tightening cycles since 1954. For each one, I charted the S&P Index (always in red in the charts) and the Fed Funds rate, from 6 months prior to the first hike to 12 months after.
Not being an economist, I am not privy to the language and its numerous nuances. The Merriam-Webster dictionary claims that “consistent” means “always acting or behaving in the same way” and that “always” allows no shades, always meaning “at all times”. It is thus shocking to see how uncooperative the S&P 500 was in 7 out of the surveyed 15 rate hike cycles (1965, 1967, 1971, 1974, 1977, 1983 and 1994).
Then there is the word “typically” like in “In fact, the first 25% of the tightening cycle is typically the best part of the stock market cycle”. Merriam-Webster likens it to “generally or normally”. In our case here, is 8 out of 15 occurrences enough to call this typical? Here’s a nuance: in each of 1961, 1965, 1980, 1983 and 1987, the first 25% of the tightening cycle was, in fact, the best part of the stock market cycle. Not because equities rose appreciably, but rather because of what happened during the next 75% of the cycle…
Mind you, in his defense, Rosy refers to a “tightening cycle”. That may be the typical nuance. Personally, my investment vision tends to get pretty blurred over 12 months. Only economists can see through a whole cycle and are capable of splitting it in 25% increments before the actual fact.
For the record, here are the charts:
To be brief, in layman’s terms, in reality, there seems to be no consistent nor typical pattern after the first rate hikes.
However, digging a little more into the history book, I found that in 6 of the 8 years when the S&P 500 rose during the initial rate hike, inflation was actually diminishing or stable (2004). This did not verify in 1987, although the market eventually avenged itself and in 1999 when internet speculation blinded everybody.
Maybe we got ourselves a bit of a rule here: rate hike cycles are not damaging to equities in as much as inflation is not rising at the time. Since profits are generally still rising when the Fed takes its foot off the pedal, stable or declining inflation rates help sustain P/E ratios as demonstrated by the Rule of 20 (inflation in green below).
So, SHOULD INVESTORS FEAR A FED TIGHTENING? The short answer is yes. The longer answer is watch inflation.
Too many people play admirals directing skippers from their onshore tower. For them, missing high waves or hurricanes while staring at average historical weather data has as much consequence as when video gamers duck too late. But there are real skippers out there, surfing treacherous, uncharted seas. A practical admiral would favour down-to-earth (!) analysis and prognostics that would allow investors to better understand the true risk/reward profile immediately ahead.
In truth, David Rosenberg deserves his 5 stars as a smart and thorough economist. It would be best if he would apply the same rigor as a strategist.