Is a Fed Easing Cycle Worth Buying Into?

Wall Street teems with folklore surrounding appropriate trading strategies at various points in the economic cycle, election calendar, and calendar year. There’s the annual “Sell in May and go away” advice which dictates that profit opportunities in the broad market are typically subdued from May until the Labor Day. There’s the presidential cycle phenomenon, where stocks generally perform poorly in the first two years of a presidential cycle and well during the second two years. (Further analysis by William Hester of Hussman Funds points to some interesting sub-trends likely playing into this year’s final quarter.)

Today, with long-term interest rates low, commodity prices collapsing, and economists envisioning a slowdown on the horizon due to a cooling housing market, the idea that the next Fed move is more likely an easing than a tightening is gaining credence amongst market participants.

More often than not, discussion of possible Federal Reserve interest rate easing is coupled with seemingly boilerplate market commentary noting that lower interest rates provide a positive catalyst for market returns and prodding investors to front-run the Fed and gain exposure to a stock market that’s poised to move higher.

Nice story. Clean, intuitive. A “feel-good” outlook that’s always appealing.

But what does the data show. We examined market returns during both Fed easing and tightening cycles to unearth the reality behind the myth. Specifically, using S&P 500 price returns from 1954 through this month along with historic Fed funds rates, we look at how the broad market performed 2-months before a shift in Fed policy through 36-months after the initial move took place. We note the following upfront:

• market returns for the S&P 500 series we used didn’t include dividends, so they’re a bit lower than investors would have realized


• due to the small number of sample points, eleven easing and tightening cycles, the averages aren’t statistically significant.

That said we’re after general trends, not detailed statistics, so we’re comfortable with the limitations of our analysis.

Fed Easing
Contrary to popular opinion, average returns realized following the commencement of a Federal Reserve easing cycle have been abnormally weak for the first year after the change in policy took effect. Through the first thirteen months the stock market has generated price returns of slightly less than 1% cumulatively with a maximum of 30% (April 1995 easing cycle) and a minimum of -20% (July 2000 cycle).

Interestingly, cumulative market returns from two months prior to the beginning of a Fed easing cycle were uninspiring as well; down roughly 0.70% cumulatively.

Beyond thirteen months into a Fed easing cycle the market has generally fared well, rising 22.5% in year two (months 12-24) and 12.9% in year three.


Fed Tightening
Perhaps paradoxically stock market returns leading up to, and during, the early stages of a Fed tightening cycle have been quite robust. From two months prior to the first Fed tightening to the start of the cycle, the market gained an average 3.8%.

More interestingly, from the start through the first ten months of the tightening campaign the market averaged gains of an additional 10.85%, with a maximum of 35% (October 1986 tightening cycle) and a minimum of -10.7% (July 1961 campaign). Only in the 1961 cycle did stocks post a negative cumulative return during the first ten months.

Beyond ten months into historic tightening cycles, stock market returns began to suffer. The average second year returns (months 12-24) weighed in at -4.6%, while returns in year three recovered by 9%. The maximum drawdown occurred between months ten and twenty-four; a cumulative -8.5%.

Easing vs. Tightening
While we stress that the numbers presented aren’t statistically significant the stock market return trends displayed in Fed easing vs. tightening campaigns is insightful nonetheless. Investor’s would be wise to keep a few ideas in mind with regards to tight versus loose money environments.

Since 1954, stock market returns have lagged the beginning of Federal Reserve monetary campaigns by between ten and thirteen months on average

The first thirteen months of Federal Reserve easing campaigns have been associated with abnormally weak stock market returns.

Our conjecture - The monetary authority typically begins an easing cycle only when the economy has shown clear signs of faltering. In the early stages of an easing campaign the economic benefits of future expected rate cuts are more than offset by the effects of a slowing economy, leading to sub-par stock returns.

• Historically, stock market returns have remained robust up to ten months after the beginning of a Federal Reserve tightening campaign.

Our conjecture - The monetary authority typically begins a tightening cycle only when the economy has shown clear signs of overheating. In the early stages of a tightening campaign the strength of the underlying economy more than outweigh the future effects of higher interest rates, leading to continued strong gains in equity valuations.

While common wisdom holds that investing in stocks at the beginning of a Fed easing cycle provides investors a fantastic opportunity to capture equity market returns, it’s not clear to us that this is an optimal strategy. More appropriate may be a strategy of maintaining an overweight in the long-end of the government bond market twelve months into an easing campaign before switching to stocks.