When the Fed Stops Tightening

Indeed, 1980 seems to be a dividing line when it comes to the Fed. In the majority of cases from 1980 forward, markets did rather well after the Fed finished. Prior to that year, markets were generally lower six and 12 months after a tightening cycle ended.

In October 1982, the Fed shifted its emphasis from money-supply measures and "nonborrowed reserves" to an explicit fed funds rate-targeting procedure. That could very well be part of the basis for the change in results after Fed tightening ends. (See: When Did the FOMC Begin Targeting the Federal Funds Rate? for more detail.)

My conclusion is that the context of the Fed hiking cycle is what matters most to markets. During secular bull markets, Fed tightening seems to cool inflation and allows markets to keep rising. During bear periods, the Fed cycle seems to stop just before a major economic slowdown begins. The decrease in revenues and earnings then pressures equity prices.

Let's examine some of these other studies. InvesTech Research looked at market performance over the following three, six and 12 months after the end of a tightening cycle, from 1929 to 2000:

S&P 500 Gain/Loss After Final Discount Rate Hike

Source: InvesTech

The study found that prior to 1982, nine of 11 cycles ended with stocks lower six months later. From 1982 forward, markets have been higher two of three times. (Note that InvesTech did not include 1984 as a full cycle, which was a positive year for stocks.)

Next up: Ned Davis Research, which also compiled all of the Fed hiking cycles over the past 75 years. The organization found that, going back to 1929, the S&P 500 was actually lower six months after the last rate increase 71% of the time, and down 64% of the time 12 months later.

The silver lining in the Ned Davis study was that, since 1980, the Fed has tended to start lowering rates -- on average -- six months after its increase. This may explain the bullish findings during the 1980-2000 period.

A third study was conducted by Birinyi Associates. It put together a composite chart of the post-Fed tightening cycles by creating an overlay of what all the tightening cycles looked like -- from the last hike to the first cut -- since 1962:

Source: Courtesy of Birinyi Associates

Note that the euphoria surrounding the end of the Fed cycle often leads to an initial 1% to 2% relief rally; that subsequently gives way to an 8% average drop, a 4% bounce, and then a revisit to the lows. The accompanying chart looks none too encouraging.