Your Economy (No Politics)

[Bullwinkle]

End of Fed Tightening Cycle Not Bullish
Comstock Partners, Inc.
Friday, January 26, 2006


The current conventional wisdom that the end of Fed tightening is immediately bullish for stocks is simply not supported by history. In looking at the last rate hike in all 16 instances going back to 1920, we found that the Dow Jones Industrial Average declined by an average of 19.1% from the date of the last rise in rates to the eventual market bottom. In fact the Dow dropped by at least 10% in 12 of the 16 instances and by more than 20% half of the time. In only four cases did the Dow actually rise after little or no decline, and one of these times was in early 1995. That is why Wall Street likes to bring up that one case while ignoring the bulk of the evidence.

In looking at the way events have typically unfolded in previous cycles, it makes a lot of sense that stocks fall significantly following the last Fed rate hike. The Fed’s usual objective in raising rates is to prevent or stop inflation in a mature economic expansion, and it generally stops when the policy shows signs of working. However, since changes in monetary policy work with lengthy and uncertain lead times, the last few rate hikes are still kicking in for some time after the policy changes direction. Therefore it is usually after the last rate hike that the economy slows significantly and earnings fall out of bed. Since this generally happens following a period of overvaluation and optimistic sentiment, disappointed investors then leave the market in droves as they focus on the highly negative fundamental news despite the change in Fed policy.

Given both the past odds and the current condition of the economy and stock market, we think it likely that stocks will decline significantly either before or after the final Fed rate hike. Stocks are overvalued, and the rally since October has largely discounted the event in advance. The slowdown in housing will impact consumers’ ability to extract cash from their home values at a time when household debt is at record levels, wage and salary gains are anemic and savings rates are negative. In addition none of this analysis allows for the possibility that the economy remains strong or that rising energy prices threaten to spread. In that case the final rate hike would be even further down the road. All in all we think the widespread belief that the end of rates hikes will spark the market is based on a misreading of the evidence, particularly in view of current market and economic conditions.

http://www.comstockfunds.com/index.cfm/act/newsletter.cfm/CFID/3100225/CFTOKEN/15616716/category/Mar...