What Really Happens When the Fed Stops Tightening Comstock Partners, Inc. Thursday, March 23, 2006
Since the market has been rallying on any sign of economic weakness and declining on economic strength, it easy to see that investors are playing for a rally once the Fed stops hiking interest rates. What’s more, both Wall Street and the media are giving the impression that this is normal by constantly referring to the major market rise after the Fed stopped tightening in early 1995. What they are ignoring, however, is that the 1995 experience is the exception rather than the rule. Simply put, there have been 12 periods in the last 53 years where the Fed has engaged in a series of rate hikes. In 10 of these instances the S&P 500 subsequently declined AFTER the final rate increase, with an average drop of 22% to the eventual bottom. On average the market bottom occurred 10 months after the end of tightening. Importantly, an economic recession followed in 9 of the 12 cases. On average, the peak of economic cycle took place 4 months after the last rate increase, although in two instances the peak actually occurred first, meaning that the last tightening was implemented after the recession started, but before the Fed was even aware of it.
Since the history is so clear that the probabilities point to a significant market decline and recession after the last Fed rate hike, it seems to us that investors are battling against overwhelming odds in assuming that this time will be different. They are rooting for economic weakness because they know that this will induce the central bankers to stop raising rates soon. The problem, though, is that the lead time between rising rates and their impact on the economy is fairly long, and that once the Fed sees an actual softening in the economy it is usually too late to prevent the most recent rate hikes from taking the economy from mere softness to recession. Investors therefore end up wanting to see the economy weaken, but at the same time they stick with their forecasts of robust economic growth and strong earnings gains. They are then able to remain bullish on the grounds that the Fed will stop tightening soon while the economy will stay strong with earnings showing good gains. In our view these two results are inherently contradictory, as history strongly indicates. In the current situation we think a bear market and recession is even more likely than in prior periods of Fed tightening because of high market valuations, soaring energy prices, higher non-energy commodity prices, the record trade deficit, the huge household debt-to-GDP ratio, and the potential unwinding of the housing boom. When we also consider that the consensus of economists has never forecast a single recession and the vast majority of investors have never seen a bear market coming, why take their current rosy predictions at face value when indicators with a far better record of forecasting are saying the opposite? We prefer going with the stronger probability. As Damon Runyon once said, "It may be that the race is not always to the swift, nor the battle to the strong--but that is the way to bet."
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