When the Fed Stops Tightening

The fourth, and final, study is from Comstock Research. It looked at the 12 periods during which the Fed has engaged in a series of rate hikes over the past 53 years (1953 to present). Comstock concluded: "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 nine of the last 12 cases."

On a final note, Merrill Lynch's chief North American economist, David Rosenberg, took a very different tack. He goes one step further and notes that not only do markets exhibit "lackluster performance post-Fed tightening cycles," but points to periods of "financial crisis" shortly after the Fed goes on hold.

• When the Federal Reserve finished its tightening cycle by September 1987, markets plunged the very next month. "It wasn't a case where the Fed was tightening on the 16th and the market crashed on the 19th," Rosenberg writes.
• In May 2000, the Nasdaq Composite was flat year to date, following a rally and then a selloff. The Fed had ended its tightening campaign of six hikes in 11 months, including a half-point raise. Nasdaq lost more than 40% in the following six months.
• The Fed tightened rates seven times from 1994 to 1995. The strains on the economy were felt late in 1995, as GDP slowed to 1.1% and 0.7% the following two quarters and Treasury yields rose 30%. However, 1995 was a positive year for stocks.

In conclusion, since the formation of the Federal Reserve, the end of a tightening cycle has been a negative signal for equities.

The exception has been the recent tightening cycles during the 1982-2000 bull market. The cycles ending in August 1984, February 1989 and February 1995 were net positive, while the May 2000 -- well, I don't need to remind you what followed that cycle. Whether the change in fed funds targeting is partially responsible has not been conclusively determined.

The bottom line: The Fed stops tightening when it sees the economy slowing dramatically. The weakness affects revenue and earnings. With profits plummeting, all the supposedly cheap stocks (based on P/E) are suddenly not so cheap anymore. That leads to a market correction, which starts the entire process all over again: recession, cheap stocks, Fed cutting, buying opportunity.

Investors need to be patient, and not jump the gun on the upcoming buying opportunity.