Innovation Update

When the Fed Stops Tightening

Stock quotes in this article: ^IXIC , ^SPX  

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.

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Barry Ritholtz is the chief market strategist for Ritholtz Research, an independent institutional research firm, specializing in the analysis of macroeconomic trends and the capital markets. The firm's variant perspectives are applied to the fixed income, equity and commodity markets, both domestically and internationally. Other areas of research coverage also include consumer, real estate, geopolitics, technology and digital media. Ritholtz is also president of Ritholtz Capital Partners (RCP), a New York based hedge fund. RCP is driven by the analysis performed by Ritholtz Research. Ritholtz appreciates your feedback; click here to send him an email.

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