When the Fed Stops Tightening Comstock Partners, Inc. Thursday, August 3, 2006
Question from a reader—“…I wonder why another source says something exactly the opposite of you with regards to the state of the market following the end of Fed tightening. I presume the answer lies in the timing. Here is a quote from (name deleted):
“ ‘ When the Fed quits raising rates, 9 out of 10 times the market is higher 12 to 18 months later. I expect a lot of this move to come during the next six months.’
“How does this data gel with your comments that 9 out of 10 times there is a bear market after the Fed stops hiking rates?”
Answer—there have been 12 periods in the last 53 years where the Fed has engaged in a series of rate hikes. In 10 of those 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 last 12 cases. On average the economy did not peak until 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.
What investors and traders want to know is the direction of the market after the final rate hike, and in 10 of 12 cases the answer was that it was down. To be sure, after markets go down they eventually recover. It’s a given that bull markets follow bear markets, but we want to assess which one is likely in the period ahead. In assessing the strengths and weakness of any system of investing, it is extremely important to know what the maximum and average drawdown has been in the past.
In that sense it can be highly misleading to select arbitrary future dates such as 12 months or 18 months. For instance, in the prior tightening cycle the last rate hike took place on May16, 2000. One year later the Dow was up 2.6%, so this is one instance where observers could say that the market was up one year after the last hike. However, the bear market was far from over as the Dow did not bottom until October 2002, when it was 34% lower than at the time of the last rate hike. The S&P 500 and Nasdaq did even worse, declining by 42% and 70% respectively over the same period.
The late Senator Moynihan once said that “Everyone is entitled to their own opinion, but not to their own facts.” We believe the facts are clear that in the vast majority of instances, the final rate hike in a tightening cycle has been followed by a bear market.
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