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- Mar 25, 2010
Stocks in Rate-Hike Cycles
The stock-market outlook in 2016 is riddled with great uncertainty following the Fed ending its 7-year-old zero-interest-rate policy. With the first rate-hike cycle in nearly a decade just getting underway, traders are anxiously wondering how it will impact the stock markets. While raising rates out of ZIRP is radically unprecedented, stock-market reactions during past rate-hike cycles still offer some interesting insights.
The Federal Reserve’s monetary-policy decisions are no longer peripheral concerns for stock-market fortunes. Thanks to the Fed’s extreme easing of recent years, its actions have usurped everything else to become the stock markets’ overwhelmingly dominant driver. And unfortunately the wildly-outsized upside impact on stock prices by the uber-dovish Fed is highly likely to portend proportional downside.
This all started back in late 2008’s once-in-a-century stock panic, when the Bernanke Fed joined in the panicking. On December 16th, 2008, the Fed’s Federal Open Market Committee that makes its policy decisions slashed its benchmark federal-funds-rate target by a staggering 100 basis points (hundredths of a percent) to zero. This was the first time in the Fed’s entire history since 1913 that it implemented ZIRP!
But once it bullies rates to nothing, the Fed hits the zero lower bound where it can no longer cut rates to attempt to stimulate the economy. That leaves its final option of money printing, conjuring up new money out of thin air. Weeks before ZIRP was born, the Fed was already spinning up its first debt-monetization campaign known as quantitative easing. This pleasant euphemism obscures the fact this is pure inflation.
So since late 2008, the monetary environment in the United States has been epically unprecedented. The Fed has stormed so far into uncharted territory that it defies belief. In the last normal year of 2007, the federal-funds rate averaged 5.0%. That’s right in line with the quarter-century average ending that year of 5.5%. During the subsequent ZIRP years since, the FFR averaged nearly 98% lower at 0.13%!
In 2007 the Fed’s balance sheet averaged $830b. The Fed’s extreme QE money printing ever since has ballooned this to an average of $4450b in 2015, a mind-boggling 5.4x higher! If the Fed had grown its balance sheet at a reasonable rate around 7% annually, it would only be 1.7x higher today or $1425b. It’s exceedingly important to remember the past 7 years’ monetary policy has been the most extreme ever by far!
Such a crazy-easy Fed was tremendously bullish for the stock markets, especially starting in early 2013 when its third quantitative-easing campaign spun up to full steam. QE3 was very different from its predecessors in that it was open-ended, with no predetermined size or end date. Top Fed officials deftly used this to their advantage, aggressively jawboning the stock markets higher through an implied Fed Put.
Every time the stock markets started sliding into a normal healthy pullback, Fed officials would rush to the podiums to reassure they were ready to expand QE3’s bond monetizations if necessary. This effective central-bank backstop seduced stock traders to keep buying back in, ignoring all normal market indicators. The result was recent years’ extraordinary Fed-conjured stock-market levitation, a wildly-unprecedented anomaly.
Keep these vast Fed distortions in mind as you consider stock-market behavior during past Fed-rate-hike cycles. The incredible and record-setting-in-many-ways stock-market levitation leading into this latest rate-hike cycle was the direct result of the easiest Fed ever seen by an enormous margin. So there’s a very high probability the mean-reversion aftermath will be proportionally as severe and record-setting.
Nevertheless, the stock markets’ behavior in past Fed-rate-hike cycles is still worth studying. I recently completed a deep-research project looking at every FOMC decision changing its federal-funds-rate target since 1971. It turns out this happened a whopping 252 times over this span! Since the FOMC meets 8 times per year, that works out to FFR target changes happening at over 2/3rds of the 360ish meetings.
Provocatively the Fed doesn’t always hike rates in cycles, a series of multiple sequential hikes with no intervening cuts. There were 6 times in that nearly-half-century history where the Fed made one lone hike that was bracketed by cuts. There were an additional 6 times where the FFR target was raised twice in succession before it was reduced again. One or two isolated hikes certainly don’t make a rate-hike cycle.
The most generous definition possible for a Fed-rate-hike cycle is 3 or more consecutive FFR increases with no interrupting decreases. It turns out the Fed has executed fully 11 of these rate-hike cycles in the 45 years since 1971. The charts below reveal the benchmark S&P 500 stock index’s performance over the exact spans of these cycles, starting the days of their first hikes and ending the days of their last ones.
While all rate-hike cycles are highlighted in light red, these don’t always perfectly match the troughs and peaks in the federal-funds rate. The Fed actually doesn’t directly control the FFR, which is technically a free-market interest rate determined by federal-funds supply and demand. Commercial banks use this market to borrow and lend their required cash reserve deposits held at the Fed on an overnight basis.
The Fed instead sets an FFR target, which it then attempts to achieve through open-market operations where it directly buys and sells in the federal-funds market. While the Fed’s sophistication in bullying the FFR to its target has grown over the years, there are still deviations. Bending the free market to its will can literally take tens of billions to hundreds of billions of dollars of trading, it certainly isn’t a trivial task.
A half-dozen key data points are noted for each Fed-rate-hike cycle. They start at the top with the total increase in basis points. That’s followed by the number of individual hikes in each cycle, as well as their average basis-point increases per hike and per month. After that is each rate-hike cycle’s duration measured in months, finally followed by the S&P 500’s performance during each cycle’s exact span.
Recent months’ raging debate about this newest rate-hike cycle’s likely impact on the stock markets has been something of a Rorschach test, revealing traders’ inherent biases. Stock-market bulls argue that Fed rate hikes are bullish for stocks, because the Fed wouldn’t dare raise rates unless the underlying US economy is really improving. I’ve heard this case being made hundreds of times on CNBC recently.
Meanwhile the stock-market bears believe Fed rate hikes are bearish for stocks because they mark the end of the easiest monetary policies on record which levitated the stock markets. Take away the gigantic hot-air injectors of ZIRP and QE, and the artificial balloon they inflated shrivels up and collapses. It is rather amusing to see stock markets’ historical action during past Fed-rate-hike cycles support neither thesis!
The S&P 500 (SPX) climbed in the majority 6 of the 11 Fed-rate-hike cycles of the modern era, with an average gain of 11.1% during these wins. That’s pretty darned impressive, since the average duration of those particular rate-hike cycles was just 10.6 months. If that kind of performance is coming again, the bulls will rejoice. But during the other 5 cycles, the SPX lost 7.1% over an average duration of 13.5 months.
If the SPX’s performance during all 11 Fed-rate-hike cycles is averaged together, it is almost a wash with a mere 2.8% gain. This ambiguous result of a small upside bias doesn’t show clear direction either way. It’s fascinating comparing this to gold, which American futures speculators have been universally assuming will be crushed in this newest Fed-rate-hike cycle. Yet gold vastly outperformed the SPX in past ones.
Gold’s average gain during these same 11 Fed-rate-hike cycles of the modern era was 26.9%, nearly an order of magnitude greater than the stock markets’! Gold also rallied in 6 of these 11, but by a far-greater average of 61.0%. So while stock markets’ performance in Fed-rate-hike cycles has been ambiguous and directionless, gold’s has proved just the opposite. Stock-market bulls are betting on the wrong horse.
I was surprised stock markets’ historical performance during Fed-rate-hike cycles wasn’t worse. Rising interest rates hit stocks on multiple fronts. As higher rates increase debt-servicing costs throughout the economy, there is less money available to buy products and services from corporations. So rising rates lead to slowing sales, which are leveraged to a larger downside impact on overall corporate profitability.
Weaker earnings raise valuations, making stocks less attractive. On top of that, higher rates drive up the prevailing yields in the bond markets. This leads investors to migrate away from riskier dividend-paying stocks into bonds. Rate-hike cycles also prove the Fed has a tightening bias, which turns psychology on the stock markets bearish. So practically, Fed-rate-hike cycles simply shouldn’t be bullish for stock markets.
But the hard historical data didn’t bear this out, with the SPX rallying in the majority of the Fed-rate-hike cycles, seeing bigger average gains in those than losses in the others, and achieving that small overall average gain. Given the fundamental impact of higher rates on stock prices, this seemed odd. So we have to dig deeper into individual Fed-rate-hike cycles, which paints a more coherent picture of what to expect.
The stock markets meander in great third-of-a-century cycles I call Long Valuation Waves. Each wave’s first half is a mighty secular bull lasting about 17 years. These see investors flock to stocks and bid up their prices far faster than underlying corporate earnings are growing, ratcheting up their valuations. Eventually valuations grow too excessive and greed peaks, which ushers in each wave’s second half.
That’s a symmetrical 17-year secular bear, in which stock prices simply grind sideways on balance for long enough to let earnings catch up with the preceding bull peak’s lofty stock prices. Secular bears consist of an alternating series of cyclical bears and bulls, which first cut stock prices in half and then double them back up to breakeven again. These great valuation cycles explain the SPX’s rate-hike-cycle behavior.
A 16.7-year secular bull peaked back in February 1966, paving the way for a 16.5-year secular bear running to August 1982. This sideways-grinding trend of stock prices consolidating for long enough to enable profits to catch up and lower excessive valuations was the key driving force behind the markets during the first 5 Fed-rate-hike cycles of the modern era. And they saw average SPX losses of 5.5%.
If the stock markets were relatively high in their secular-bear consolidation trend when the Fed started to hike rates, they lost ground as mid-secular-bear cyclical bulls rolled over into cyclical bears. And since the Fed has always been worried about the stock-market reaction to its rate hikes due to the impact of the wealth effect on consumer spending and thus the overall economy, it never starts hiking near major stock lows.
After that in the 17.6 years between August 1982 and March 2000, the stock markets powered higher in their greatest secular bull on record. That period encompassed the next 5 Fed-rate-hike cycles, which saw average gains of 9.2%. The SPX rallied in 4 of those 5 secular-bull rate-hike cycles, compared to falling in 4 of the 5 secular-bear rate-hike cycles. This historical record is very provocative and illuminating.
The stock markets’ position within the Long Valuation Waves when new Fed-rate-hike cycles are born looks like the dominant driver of whether they rise or fall during those cycles. Fed rate hikes are likely to be ignored by stock markets powering higher in secular bulls, overcome by traders’ popular greed. But during secular bears, Fed rate hikes are overwhelmingly likely to help drive selling pushing stocks lower.
So if this newest Fed-rate-hike cycle is happening in a secular bull, stock markets are likely to shrug it off and keep on rallying on balance. But if the stock markets are really in a secular bear, rising rates will almost certainly force them lower. And unfortunately the fundamental and technical evidence is heavily in favor of the stock markets still being mired deep in the secular bear that started all the way back in early 2000.
When that last secular bull peaked, the stock markets were trading at extreme valuations up around 43x earnings. That is far into bubble territory above 28x, and the century-and-a-quarter average trailing-twelve-month price-to-earnings ratio of the S&P 500 is merely 14x. That’s fair value for stocks. After that extreme, stocks started grinding sideways giving profits time to grow into those lofty secular-bull-peak stock prices.
And indeed that’s exactly what happened between early 2000 and late 2012. The stock markets ground sideways on balance, first getting sliced in half in cyclical bears before doubling back up to breakeven again in cyclical bulls. Prevailing price-to-earnings ratios gradually normalized on balance, with underlying corporate profits rising faster than stock prices. It was a textbook secular bear until early 2013.
That’s when the Fed ramped up its wildly-unprecedented open-ended QE3 to full steam, and started brazenly jawboning the stock markets higher. So the SPX soon broke above its decade-plus secular-bear resistance near 1500 and ultimately levitated over 2100 by May 2015. This led stock investors to universally assume a new secular bull had been born, but odds are it was merely a gross Fed-conjured distortion.
When adjusted for basic CPI inflation, the S&P 500’s secular-bull peak of 1527 in March 2000 works out to just over 2100 in constant May-2015 dollars! So in righteous real inflation-adjusted terms, the stock markets have still never surmounted their last secular bull’s peak despite the extraordinary levitation the Fed fomented in recent years. The stock markets are still mired in that 17-year secular-bear sideways grind.
And with prevailing stock-market valuations just challenging 26x in recent months which isn’t far from 28x bubble territory, there’s no way this secular bear is over. Secular bears don’t end until the general-stock-market P/E ratio is way down near 7x, half fair value. Even in the dark heart of 2008’s stock panic and the subsequent early-2009 ultimate nadir, the SPX’s P/E ratio never fell much below 12x earnings.
And if the US stock markets indeed remain stuck in their long secular bear which the Fed temporarily tried to derail through the most aggressive easy-money policies in its entire century-long history, then this new Fed-rate-hike cycle is very bearish for stocks. There are high odds the stock markets will sell off on balance as the Fed hikes rates, likely seriously given today’s Fed-conjured near-bubble valuations.
And the coming stock-market selloff that Fed rate hikes will accelerate will be exacerbated by the gross distortions from ZIRP and QE in recent years. ZIRP’s impact on the stock markets was enormous, so the unwinding of ZIRP should largely reverse the SPX levitation. The primary mechanism through which ZIRP boosted stock prices so dramatically was through enormous levels of corporate stock buybacks.
With the Fed bullying short rates near zero through ZIRP, and long rates near record lows thanks to QE, the costs for corporations to borrow vast sums of money withered to all-time lows. So the majority of the elite US companies decided to undertake financial engineering to simultaneously boost their stock prices and earnings per share. They literally borrowed way over a trillion dollars to buy back their own stocks!
Over 3/4ths of the elite SPX companies engaged in stock buybacks, which bid up stock prices while also reducing the outstanding share count which increases earnings per share. This newest Fed-rate-hike cycle is going to start reversing these record-low corporate borrowing rates artificially created by ZIRP and QE. Even a modest uptick in prevailing rates will drastically alter the economics of corporate stock buybacks.
So the negative impact of the Fed hiking rates on buybacks financed with borrowed money alone are incredibly bearish for stock prices. And stock markets enjoyed a strong secondary boost in recent years from the Fed’s extreme policies forcing bond yields near record lows. This left investors seeking yields with no choice but to abandon Fed-pummeled bonds to migrate capital into far-riskier dividend-paying stocks.
With this new Fed-rate-hike cycle ending ZIRP and starting to allow bond yields to normalize again, all those legions of investors looking for yields to provide them incomes are going to start moving back into bonds. That will put even more selling pressure on stock markets as the Fed raises rates. So the selling stock markets will face as the Fed hikes rates out of record-low extremes are vastly greater than in normal cycles.
With that extraordinary stock-market levitation of recent years fueled by ZIRP going to unwind as interest rates slowly normalize, investors need to be exceedingly careful. They need to exit the overvalued stock markets and park that capital in cash or gold. Holding cash while stock markets fall grants a proportional gain in stock-share purchasing power after that selloff ends. Cash protects and preserves capital in bear markets.
But as one of the only assets that moves contrary to stock prices, gold grows capital during stock bears. Gold rallies on balance as stock markets sell off thanks to growing investment demand from investors seeking prudent portfolio diversification. Gold has actually thrived in past Fed-rate-hike cycles, enjoying exceptional average gains an order of magnitude higher than stock markets! This can be played two ways.
Investors can simply buy physical gold bullion or the flagship GLD SPDR Gold Shares gold ETF to mirror the coming gold upleg. But gold’s gains can be greatly leveraged in the left-for-dead gold stocks, which are still languishing near extreme 13-year secular lows. Their stock prices are at fundamentally-absurd levels relative to their existing profits, which will quickly soar as gold inevitably mean reverts far higher.
Gold stocks are likely to be the best-performing sector of 2016 by far, which is why we’ve aggressively bought and recommended many elite gold and silver stocks at Zeal in recent months. No other sector in all the markets is as undervalued and loathed, leaving vast room for gold stocks to soar as investors start to return. Buying in ahead of the herd before rate hikes’ impacts become apparent will yield the greatest gains.
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The bottom line is Fed-rate-hike cycles’ impact on the stock markets has been ambiguous, with the SPX seeing slightly-positive average gains. Stock markets’ performance during rate-hike cycles depends on where the markets happened to be in their long bull-bear cycles when the Fed starts hiking rates. Rate-hike cycles happening in bull markets see stocks tend to rise, and in bear markets see stocks tend to fall.
And not only do the stock markets remain mired deep in a secular bear today, but this newest Fed-rate-hike cycle is wildly unprecedented coming out of such record monetary-policy extremes. There is a very high chance that the Fed’s entire artificial stock-market levitation of recent years will be fully unwound as interest rates normalize. So the stock downside risks in this peculiar environment are far greater than normal.
Adam Hamilton, CPA
December 24, 2015
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