These congressmen seem to be approaching the Fed unnecessarily timidly. Photo by Mark Wilson/Getty Images News.
If you are anything like us, your mother probably taught you not to fight with anyone. But on Wall Street, that lesson is much more specific: An old saw holds that you aren’t supposed to fight the Fed.[i] Everyone else is fair game! Whee! Kidding. Effectively, the adage means that if the Fed is dead set on hiking interest rates—“tightening,” to use the industry vernacular—then equity investors should look out because the results will be Very Bad. If the Fed is lowering rates, cue the band and load up on stocks. This presumes liquidity is key to equity market direction, so even small changes might threaten stocks. At times true! But a faulty, wrongheaded rule of thumb that could easily lead you astray. You can fight the Fed. And win. In fact, very often you should fight the Fed.[ii]
There is a veritable cottage industry of folks within Wall Street firms who do little more than speculate on Fed moves, in part due to that old adage. These pundits are in high demand now, with central banks garnering so much attention for their “extraordinary” monetary policies, like buying long-term bonds instead of short-term, seeking lower long rates. There are a slew of funky new acronyms and words like ZIRP and the zero-bound (both of which are unnecessary jargon meaning the Fed is targeting short rates of 0%). With all this fun, it should come as no surprise investors are keenly attuned to virtually everything central bank related. The Wall Street Journal devotes a daily (!?!) newsletter (The Grand Central) to central bank-related news. Others happily provide you the full text of European Central Bank President (Mario) Draghi News Conference. Some run the policy statements through a complicated version of control-F to analyze changes from month to month. (It would not surprise us if folks began analyzing Janet Yellen’s expressions to see if she looks a tad more hawkish or dovish today.) All this is attempts the impossible: To forecast when a small cadre of folks who make monetary policy decisions will decide to raise short-term interest rates or make other moves. These are people, not things that move in step with probabilities. Handicapping the outcome is a guessing game.
Eventually, rates will rise. However, when they do, it isn’t necessarily cause for alarm. Folks often point to the six rate hikes in 1994 to suggest fighting the Fed is hazardous to your health, because stocks dropped. Yet for the year, the S&P 500 was down only -1.5%.[iii] From the hike to the close of the year, stocks fell -4.5%.[iv] Stellar? No. Did the bull end? Nope—it rose another six-plus years and 218% from the first hike.[v] The Fed hiked again the next February, and stocks didn’t fall—they rose 16.3% in the five months before the Fed’s next move, a July rate cut. (Stocks sailed higher thereafter.)
After the Tech bubble burst, you can see the reverse. The first cut came in January 2001, followed by ten more through December 2001. None were exactly great buy signals, considering the 2000 – 2002 bear market didn’t bottom until October 2002 (or March 2003, when the low was retested). You should have fought the Fed throughout this bear.
In the mid-2000s bull, you should also have fought the Fed. The first rate hike came in 2004, and four more followed that year. Yet stocks rose 9.0%. No correction hit. The bull continued until October 2007. Stocks rose 37% from the first hike to the top—“enduring” 17 fed-funds target rate hikes along the way.
In the 2008 bear, again you could have fought the Fed. It cut rates for the first time in September 2007. And stocks went up! For a month. It cut again in October and December. Twice in January. Once each in March and April. Twice in October 2008. And once in December 2008, to the “zero bound” rates sit at today. None of these stopped the bear. Fed funds cuts paled in comparison to the destruction of bank capital wrought by FAS 157, and the panic the Fed and Treasury’s other actions caused.
That brings us to today. Six years have passed since rates were changed in either direction, eight since the last hike. But we’ve seen Fed Fears, including what the media dubbed Taper “Terror” in mid-2013. After then Fed head Ben Bernanke alluded to tapering quantitative easing (QE) on May 22, long-term interest rates rose sharply. But the full effect of the so-called terror on stocks? A -5.8% peak-to-trough dip in the S&P 500 lasting 25 days amid an overall 30% year.[vi] In 2014, we’ve seen actual tapering and overall rising stocks.[vii] Fight, not flight, was right.
Exhibit 1: Taper “Terror”?
Source: FactSet, S&P 500 Price Index level, 12/31/2012 – 12/31/2013.
We aren’t recommending a strict contrarian stance, wherein any hike is a buy signal, any cut a sell. Obviously, the 1980s and 1990s bull markets began amid a series of rate cuts. It is well documented that Alan Greenspan flooded the market with liquidity in 1987 when stocks crashed and some attribute the quick rebound to this. Some ended amid hikes. But like stock market volatility, importantly, it is an error to fret all the little moves—the Fed’s wiggles—along the way. That rate hike cycles do not perfectly align with bull/bear cycles or economic cycles tells you this is not the timing tool for all time. The hike itself doesn’t cause damage. It is when the Fed over- or undershoots with inappropriate policy for the macroeconomic conditions of the day (and no one notices the error). Presently, it is hard to argue an economy growing at above-average rates in three of the last four quarters couldn’t handle a hike from ZIRP to ZIRP plus a wee bit more—and with all the fear, it is hard to argue there is anything resembling a yucky surprise for stocks when the Fed finally moves.[viii]
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[i] We admit to not having researched what people said before 1913. Don’t fight the classical gold standard? Before that, would one have really feared a financial confrontation with either the First or Second Bank of the United States? “Don’t fight Andrew Jackson” we can kinda see though, for a variety of reasons.
[ii] Please don’t take us literally here. We are not advocating anyone punch a Fed person.
[iii] Source: FactSet. S&P 500 Price Index returns, 12/31/1993 – 12/31/1994.
[iv] Source: FactSet, S&P 500 Price Index returns, 02/03/1994 – 12/31/1994.
[v] Source: FactSet. S&P 500 Price Index returns, 02/03/1994 – 03/24/2000.
[vi] Source: FactSet. S&P 500 Price Index returns, 12/31/2012 – 12/31/2013 and 05/21/2013 – 06/24/2013.
[vii] This is partly because the philosophy behind QE was wrong—it was never “easing,” which implies broader, cheaper borrowing. (Cheaper happened, broader didn’t.) It was more like quantitative tightening. But most folks didn’t see this and presumed tapering QE meant tightening, and they feared fighting the Fed.
[viii] “Wee bit more” is a technical term. Kidding. It’s just a generalization for smallish rate hikes, like the Fed’s typical 25 or 50 basis point moves.