Historical Trends Suggest Stock Markets Tend to Shift Significantly in This Direction Following Fed Interest Rate Reductions
Last week was a significant period for Wall Street and investors. The famous Dow Jones Industrial Average (1.18% increase), which added two new components on Friday, along with the benchmark S&P 500 (1.09% increase) and the growth stock-driven Nasdaq Composite (1.03% increase), all reached record-breaking closing highs.
While the surprising U.S. election outcome, with former President Donald Trump becoming president-elect, contributed a large portion to these gains, it's essential not to underestimate the role of our nation's central bank in fostering optimism on Wall Street.
The Federal Reserve's influence on monetary policy
The Federal Reserve determines interest rates in the U.S. by adjusting the federal funds rate and occasionally engaging in open-market operations, such as buying or selling long-term Treasury bonds to affect yields. The aim for the U.S. central bank is to maintain a healthy U.S. economy while keeping inflation in check.
Initially, it may seem that the Fed's ability to control interest rates through the federal funds rate would have significant, either positive or negative, implications. Lower interest rates, for example, make borrowing more affordable for businesses, potentially leading to increased hiring, innovation, and acquisitions.
Conversely, if the central bank increases interest rates, it implies that personal and corporate lending will decrease, and the economy will slow down. However, it often takes more than a year for alterations in the federal funds rate to have a noticeable impact on the U.S. economy and inflation rates. As a result, the Federal Reserve is more reactive than proactive when making decisions about monetary policy.
Rate-easing cycles and their historical impact on stocks
Comprehending monetary policy as bullish or bearish for stocks may seem straightforward; however, the opposite is usually true.
For instance, the Fed employs rate-hiking cycles when the U.S. economy is performing well. In March 2022, they boosted interest rates to curb rapidly escalating inflation, which eventually peaked at over 9% on a trailing 12-month basis.
Alternatively, when the U.S. economy isn't doing well or there are unexplainable events, the Fed lowers its federal funds target rate. Although lower interest rates are generally beneficial for businesses, historical data suggests that rate-easing cycles are often a cause for concern on Wall Street.
Since the beginning of the 21st century, there have been four rate-easing cycles, including the current one, during which the Federal Reserve reduced its federal funds target rate by 25 basis points last week. Notably, following the three previous rate-easing cycles, all major stock indexes experienced significant drops.
- Jan. 3, 2001: Over a period of 11 months, the Fed reduced its fed funds rate by 475 basis points to 1.75%. However, it took 645 calendar days before the stock market bottomed out after the initial rate cut on Jan. 3, 2001.
- Sept. 18, 2007: As the first signs of the financial crisis emerged, the Fed reduced its fed funds rate from 5% to a range of 0% to 0.25% over a 15-month period. It took 538 calendar days for the market to reach its nadir after this initial rate cut.
- July 31, 2019: Within the seven months preceding the onset of the COVID-19 pandemic, the Fed reduced its federal funds rate by 200 basis points to a range of 0% to 0.25%. It took 236 calendar days for the market to reach its lowest point after the first rate cut.
In the 21st century, the Dow Jones, S&P 500, and Nasdaq Composite have, on average, taken approximately 473 calendar days, or roughly 15.5 months, to find their bottom once the Fed kicks off a rate-easing cycle.
Balancing patience and perspective
Considering historical trends over the past 24 years, rate-easing cycles usually herald trouble for Wall Street. Yet, it's crucial to remember that economic cycles and bear/bull markets are anything but straight lines.
Recessions may be disappointing or even frustrating for Americans and investors, but they're an inherent and inevitable aspect of the economic cycle. What's significant about economic downturns is their speed of resolution.
Since the conclusion of World War II in September 1945, the U.S. has experienced a dozen recessions, nine of which were resolved within 12 months. Not one of the remaining three recessions surpassed 18 months in duration.
Conversely, the post-World War II period has also seen two growth phases that endured for at least 10 years, as well as numerous multiyear economic expansions. Investors who believe in the long-term growth of the U.S. economy are well-positioned for success.
Patience and perspective are invaluable tools that should never be disregarded on Wall Street.
It's been declared. We've entered a fresh bull market. The S&P 500 has climbed an impressive 20% since its lowest close on 12/10/22. Contrast this with the previous bear market, which saw the index plummet by 25.4% over 282 days. Check out the details at this link: https://t.co/H4p1RcpfIn. Here's a related image: pic.twitter.com/tnRz1wdonp
This analysis was shared on social media by Bespoke Investment Group in June 2023, shortly after identifying the S&P 500 as being in a new bull market. Bespoke's research team delved into the duration of each bear and bull market in the S&P 500 since its inception in the midst of the Great Depression in September 1929.
Their findings? The average bear market in the S&P 500 lasts only about 9.5 months, or 286 calendar days. Comparatively, the typical bull market spans out to 1,011 calendar days. This figure has even increased post-June 2023, considering the data set used for the calculations.
Intriguingly, 14 of the S&P 500's 27 bull market spells, including the current one, have surpassed the duration of the lengthiest bear market.
While we've experienced such swings in the past and interest rate reductions might hint at a significant downturn for stocks, the broader perspective for equities and the U.S. economy remains brimming with optimism.
After analyzing historical data, it's notable that rate-easing cycles, such as the recent one, often precede significant drops in major stock indexes. For example, following the three rate-easing cycles since the beginning of the 21st century, the Dow Jones, S&P 500, and Nasdaq Composite all experienced significant downturns.
Investors who wish to leverage their funds effectively might consider exploring opportunities in investing or rebalancing their portfolio during periods of rate hikes, as lower interest rates can often lead to increased borrowing, which can benefit businesses and potentially boost the economy.
