By James Puplava
When should investors start worrying about another major correction and bear market in stocks? Ironically, when things start to get better, not worse.
In a recent Big Picture broadcast, "Yelling Yellen and the Change in the Fed's Direction," we explain the four primary phases of monetary policy and how they've influenced the stock market and economy over the last half century.
In phase 1, the Federal Reserve is transitioning from a low interest rate environment to gradual tightening. This happens as the economy starts to improve and inflation begins to rise. Think 2004 as Greenspan started to raise interest rates in quarter point increments from extremely low levels. In this phase P/E multiples and the bond market begin to peak with the historical mean return on stocks around 10%.
In phase 2, monetary policy is now much more restrictive and well into tightening mode. The economy is doing quite well and inflation is running much higher. Commodity prices begin to climb steadily and profit margins are beginning to get squeezed with rising input costs. Think 2006 and 2007 as interest rates rose to 5%. This is a deadly combo for stocks and the economy, and typically the time when investors should start worrying. (Note: We're not yet in this phase with low economic growth and inflation.) The historical mean return for stocks in this phase is around 2.5%.
In phase 3, policy is tight, interest rates have peaked and may now be rolling over. The stock market has corrected and the economy is either in or very near recession. Think 2008. In this phase, the historical mean return of stocks is -9%.
In phase 4, monetary policy is loose once again, the economy is in recovery mode, and inflation is running low. This is the best phase for stocks with a mean return around 23%.
So which phase are we in? Given the above, we say the U.S. is near the latter stages of phase 4, with Yellen's recent remarks of possibly raising rates in 6 months serving as a signal when we transition into phase 1 of the Fed rate raising cycle.
Is it time to be worried then? As you've probably heard over and over again, a bull market climbs a wall of worry. Yet, given the ebb and flow of the economy, stock market and interest rates over the last half century, investors really need to start worrying, ironically, once things are doing much better: the economy is running on all cylinders, inflation is high, and the Fed has been raising interest rates for quite some time. That's when the bubble bursts.
Right now, we're just not there yet.