William Hester writing for Hussman Funds is addressing the question Must Stocks Rise Following a Cut in the Fed Funds Rate?
Since 1955 there have been 11 periods where the Fed lowered rates at least once after raising them multiple times. Average returns have been strong during these periods. Following the first interest rate cut, the S&P; 500 has advanced at annualized rates of 23.9% over the following 6 months, 18.3% over the following 12 months, and 18.7% over the following 18 months.
Segmenting the data by valuation quickly highlights the role that cheap markets play in affecting stock market returns. During periods where the S&P; 500 price-to-peak-earnings multiple was less than 15, an initial rate cut was followed by annualized S&P; 500 returns of 43.2% over 6 months, 26.1% over 12 months, and 25.4% over 18 months.
Good returns followed nearly every instance that a rate cut took place at low valuations. This is because the Fed often begins cutting rates only in the later portions of bear market declines. The Fed began easing rates in December 1974 when stocks were trading at 7 times earnings. Two more easing cycles began in 1980 and 1981, when stocks were trading at less than 9 times earnings. The 1990 easing cycle began when the S&P; was priced at 12.5 times peak earnings.
In contrast, rich valuations have produced far more tepid returns. When the S&P; 500 price-to-peak-earnings ratio has been above 17, the market’s annualized return following the initial rate cut was –2.3% over the following 6 months, 5.9% over the following 12 months, and 6.2% over the following 18 months. Though there are fewer occurrences of rate cuts at higher valuations, they’re also more varied.
The conclusion, stated upfront was “The strongest stock market rallies after an initial interest rate cut have occurred during periods very different than today.“
It’s hard to argue with solid data and Hussman Funds has a chart to prove it (see above link). Also note that historically the market does not react UNTIL the second cut. Here we are some 6 months in advance of a presumed rate cut that may not even occur. I do think one or more rate cuts later this year are extremely likely but the bulls are trumpeting “the second half rate cut” already and have been for months. Are we looking forward to a massive sell the news event?
I am also wondering if anyone remembers “the second half recovery” chant a few years ago. That chant droned on for close to two years before a recovery finally happened.
More to the point, valuations here are NOT cheap. Valuations only look cheap much the same way that valuations of subprime lenders like NEW and LEND looked cheap. Was New Century Finance cheap at $40? It sure looked that way on a PE basis. Is it cheap now a few months later at $1.65?
Current earnings not cheap, in fact they are an out an out mirage based on cheap credit. Take away the credit and you take away the earnings. An earnings collapse started in subprime lending and it will spread. The interesting thing is that even if the bulls are correct and the subprime disaster is contained, the odds of a huge rally heading into a recession are extremely unlikely given current valuations.
Of course the answer to the question “Must Stocks Rise Following a Cut in the Fed Funds Rate?” is that nothing “must” happen either way, but the probabilities of anything good happening once the Fed is forced to cup in an upcoming slowdown are simply not very good even if one presumes that subprime contagion does not spread. A “double whammy” will occur when the subprime contagion spreads and we see the forward earnings for what they really are: a mirage.
Mike Shedlock / Mish