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With the Federal Reserve cutting rates two times in the last six weeks, investors are considering both sides of the stock market coin:

  • HEADS: Should I play the reflation trade by adding to my stock [S&P 500 (SPY), Dow Industrial Average (DIA), Nasdaq 100 (QQQQ), iShares Emerging Markets (EEM), iShares EAFE (EFA)), commodity (Energy (XLE), PwerShares Commodity (DBC), iShares Commodity (GSG)), and precious metals holdings (Gold (GLD), Silver (SLV), Central Fund of Canada (CEF)]? Or,
  • TAILS: Should I be worried the Fed sees something the market is missing and get more defensive or outright bearish [Lehman's 20r+ year (TLT) and 7-10 yr Treasury Bonds (IEF), UltraShort S&P 500 (SDS), Proshares (DXD) and (TWM)]?

If flipping a coin was considered an appropriate method to determine if stocks would be higher or lower twelve months from now, it would be prudent to invest your assets equally to accommodate both outcomes. Unlike the flip of a coin, real world odds in the stock market are not 50/50. In an effort to improve our odds of success, it may be helpful to review the past to assess how the market has reacted when the Fed cut rates multiple times in a short period of time.

When beginning a new rate reduction cycle, it is somewhat rare for the Federal Reserve to cut interest rates in consecutive meetings. Rates are more typically cut in a stair-step fashion with some pausing between cuts. Since 1971 when starting a new rate-reduction cycle, the Fed has cut rates in consecutive months seven times (1974, 1980, 1981, 1984, 1989, 1998, and 2001). While we know the market will not follow the same path as any historical comparison, it is helpful to attempt compare today’s rate-reduction environment to similar historical periods. Using the correlations in Table 1 and the relative variance (or similarity) between today’s economic data and the economic data from previous Fed rate-reduction cycles, we can better understand which periods are most similar to the current environment.

For example, if we compare the Federal Funds Rate of 5.25% in September of 2007 (prior to the first cut) , to the rate in September of 1998 (5.50%) and the rate found in February of 1980 (15.0%), we see, based on this one factor, 2007 is more similar to 1998 than 1980. If we find the relative variance between today’s economic figures shown in Tables 2-A thru 2-C and those of the past, we can build a simple mathematical model to assign a percent similarity to each past period in the study.

The results, based on all the economic factors and the correlations in Table I, show 1998 is most similar to today’s environment (Table 3). Unfortunately, 1998 is closely followed by 1981, a period which was not kind to investors despite two consecutive rate cuts at the beginning of the new Fed cycle.

We can match the similarity weights in Table 3 with the stock market’s performance one year after the first Fed rate cut to calculate a weighted return (Table 4). Based on the similarity-weighted one-year return of 3.09% for the S&P 500, we conclude there is a slight bias towards the upside for stocks relative to the closing value of 1,476 on September 17, 2007.

Table 4 can be thought of as a probability distribution for S&P 500 outcomes from September 17, 2007 to September 17, 2008. For example, based on the factors used in this analysis there is a 28.09% chance the S&P 500 will be 20.91% higher one year after the Fed’s September 18, 2007 rate cut. There is also a 26.94% chance stocks will be 17.88% lower. If you add up all the probabilities for positive outcomes in Table last, you get a 54.96% chance stocks will be higher in September of 2008. That leaves us with a 45.04% chance of stocks being lower. The slight positive bias to the upside is about a 10% improvement over flipping a coin (a probability of 54.96% is 9.92% improvement over 50/50 odds). However, the analysis may open our eyes to the reality of good or not-so-good returns for stocks between now and September 2008. Based on many factors beyond the scope of this article, including Japan’s prolonged deflation problems, high debt burdens at all levels of the U.S. economy, the importance of the wealth effect, and Mr. Bernanke’s writings, maintaining a slight bias to the reflation trade seems to have a slight edge over becoming overly defensive.

Another significant reason to maintain a positive bias is the Dow, S&P 500, and NASDAQ are all above their 50 and 200-day moving averages. In an environment filled with credit, derivative, and structured-investment-vehicle (SIV) uncertainty, keeping an open mind and an eye on the 50 and 200-day moving averages may be the best game plan. While there are currently numerous reasons to be fearful, it may not be wise to make any radical allocation changes until we see the major stock averages begin to confirm those fears by a fairly prolonged breach of their 200-day moving averages. The adage "the market can stay irrational longer than you can remain solvent" is worth keeping in mind if you are entertaining the thoughts of shorting stocks.

While the weighted similarities in Table 3 say today is most similar to 1998 and 1981, it should be noted June of 1981 already had a high-inflation rate of 9.78% vs. published figures of 1.61% in 1998 and 2007’s 2.36%. Today, investors are concerned the published inflation rate may rise during a time of less-than-conservative monetary policy. That concern is muted from an investment standpoint when compared to the situation in June of 1981 where published inflation rates were already near double-digits. Inflation is a concern today vs. a cold-hard-negative for the markets in 1981. This fact alone may give you reason to believe we are more likely headed for a 1998-reflation-trade scenario vs. the 1981-stocks-drop-by-17.88% scenario. Based on this thought process, I left 1981 out of a recent detailed analysis of stock market behavior following Fed rate cuts.

It is also helpful to know the path of the S&P 500 following the first Fed rate cut in June of 1981 and January of 2001. In 1981, the market made a higher high 57 calendar days after the first cut. It was all down hill from there to close out the twelve months after the first cut. In 2001, it took only 30 calendar days for the market to reverse course and head lower for the remainder of the twelve months. Therefore, it would be positive for stocks if we made a new high sometime after October 18, 2007 (we have not yet) and then another new high after November 14, 2007. New highs would make it less likely were we following a path similar to 1981 or 2001.

Relative performance can be thought of as the market's circumstantial evidence. As shown below, under the circumstances, there is no question the reflation trade has ruled the day since the Fed cut rates on September 18, 2007. Similarly, my proprietary asset class forecasting models based on relative performance in the last three, six, and twelve months favor reflation trade assets such as precious metal stocks, timber, and emerging market stocks. From my perspective, almost all the items above slightly favor the reflation trade over gloom-and-doom. However, the edge is small enough to remain diversified while keeping a close eye on the stock market's 50 and 200-day moving averages.

Full Disclosure: The author and his clients have long positions in CEF and DBC, as well as diversified long holdings in all the asset classes listed above.

Source: Market Behavior Following Consecutive Fed Rate Cuts