Many market participants believe that rate cuts are positive for the stock market. The argument is that the excess liquidity they foster finds its way into stocks, and that the extra spending they create bolsters corporate cash flows. Widely cited are various studies that show stocks are higher at various timeframes following a rate cut. (See here, for instance.)
The opposing argument is that rate cuts are a symbol of deeper problems with the economy. The Fed may increase liquidity from where it might otherwise have been, at least in the short run, but ultimately the general economic climate will drag down consumer spending, business profits and stock prices.
One can easily cite periods in which the market was higher during and after a Fed rate cut, and periods in which the market fell sharply. But what is most likely today? It seems to me that one key determinant would be the seriousness of the attendant economic dangers, as reflected in the length and magnitude of the Fed’s rate-cutting activity.
Goldman Sachs currently projects a Fed funds rate of 2.5% by the end of 2008. This would mark a 2.75% drop (a further 1% from today). It seems to me relevant, therefore, to examine historical periods in which the total amount of the Fed’s cut was 2.5% or higher, and in which the length of time between the first rate cut and the last rate cut was at least three months. These periods should be periods of severe threatened economic weakness, like today, as opposed to periods in which one sharp rate cut might fix the problem, or in which the economy bounced back after only mild cuts. To avoid periods of inconsistent Fed action, I required the cuts to happen consecutively, with no intervening rate increase.
These constraints lead to exactly five periods. See the chart below. (Click to enlarge; I apologize in advance if it is unreadable.)
- 7/1/74 (first cut: 13% to 9.25%) - 4/30/75 (last cut to 5.25%) - 6/2/75 (next increase)
- 6/1/81 (first cut: 20% to 15.5%) - 12/4/81 (last cut to 12%) - 1/1/82 (next increase)
- 4/1/82 (first cut: 15% to 13%) - 8/27/82 (last cut to 9.5%) - 9/24/82 (next increase)
- 6/5/89 (first cut: 9.75% to 9.625%) - 9/4/92 (last cut to 3%) - 2/4/94 (next increase)
- 1/3/01 (first cut: 6.5% to 6%) - 6/25/03 (last cut to 1%) - 6/30/04 (next increase)
- 9/18/07 (first cut: 5.25% to 4.75%) - ???
One thing that jumps out at me from the list above is that the Fed has very little room to cut rates today, assuming that we are in for protracted weakness. In fact, the smallest total cut over any of these rate cycles was 5.5%, which if applied today would give us a negative Fed funds rate! I believe this analysis will hold even if one adjusts for differences in interest rates.
Another fact: each of these rate cut cycles coincided with a recession. In fact, one might posit an alternative definition of recession: whenever the Fed cuts rates for a protracted time period, and with a certain total magnitude, that is a recession.
To complete the analysis, let’s examine how the stock market did while the Fed was cutting rates. First, we’ll measure the S&P 500’s price return during the period between the first cut and the next increase (since, to be useful, this analysis must find some way to tell that “the Fed is done”):
As I read this data, we have two periods of average returns, two periods of below average (in fact, negative) returns, and one period of above average returns.
Also interesting is the maximum decline of the S&P 500 during each one of these periods from its level on the date of the first rate cut:
If the low of 1/22/08 holds, the S&P 500’s max decline for this rate cut cycle would be 13.77%.
Here is one more way to look at the data. If I believe we are in a “protracted rate cut cycle” like the five above, then should I buy stocks today, 133 days after the first cut?
There are many ways to answer this, but here are the results (again, price only) of buying the S&P 500 133 days after the first rate cut and holding for one year:
- 7/1/74 cycle: +19.59%
- 6/1/81 cycle: +10.91%
- 4/1/82 cycle: +58.33%
- 6/5/89 cycle: -12.81%
- 1/3/01 cycle: -14.53%
These results are similar to what we found above.
My conclusion is that the conventional wisdom about protracted rate cut cycles (that they are positive for the stock market) is tenuous at best, and that one should as always perform careful and specific fundamental analysis on individual stocks before purchasing. Outside of oil service, a few selected health care names, and insurance companies with pristine balance sheets, I am finding very little to buy today. I am, however, finding plenty to short.