The Fed's Pause May Not Signal An Equities Rally

by: The Stock Advisors

In anticipation of today's FOMC meeting, many Wall Street analysts and financial media pundits have cited the potential end of Fed rate increases as a reason for investor optimism.

According to Jim Shepherd and John Bollinger, however, the historical record suggests this bullishness is misplaced. Here, they look at the history of Fed rate cycles, and the performance of equities following the final rate increase.

“From the standpoint of most in the investment community, it is believed that once the Fed stops raising rates the stock market will move dramatically higher," says Jim Shepherd in The Shepherd Investment Strategist:

Their ‘rule’ is that once the Fed stops, stocks rally.

Yet, contrary to what most of the commentators and analysts are telling you, the last increase in a rate cycle is not the time to buy stocks, at least in three of the most dramatic examples in the last twenty-plus years.

If you had followed their advice at those times, you would have lost substantial sums of money and would have missed some outstanding opportunities in other areas, such as those the model indicated. Let’s look at the first one of these referenced incidents and analyze what happened. Observe the following chart of the S&P 500 index:

In the first box, as you can see, the last rate increase in the long and painful cycle that took the Discount Rate to a punishing level of 14% occurred on May 5, 1981. If you followed the adage to buy as the Fed reached the end of the increase cycle, you would have experienced a 23% decline in stocks until the final bottom in August of 1982.

In the third box, the Fed (under its newly appointed Chairman Alan Greenspan) finished its rate increases as of September 4, 1987 as it raised the Discount Rate to the level of 6%. Was that a good time to buy stocks? I hardly think so, as you would have seen your holdings in stocks decline by 35% in just a matter of a few weeks, before finally stabilizing.

In 2000, the Fed finished its rate hike cycle as of May 19, 2000 when it increased the Discount rate from 5 ½% to 6%. As I am sure you are aware, that was just before the tech meltdown began.
"Had you invested in stocks pursuant to that rule at that time, you would have seen a temporary decline in your S&P equivalent portfolio of nearly 50%. If you had bought into the heavily touted tech sector, you would have experienced a decline of nearly 80%.

Note, however, the second box in the chart above. In this case the Discount Rate was decreased on August 21, 1986 from 6% down to 5½%. This did spark a sizeable rally in stocks, as the market soared to all time highs by August 1987. In fact, the S&P increased during that time a remarkable 38%. Indeed, that is the way to make money in stocks.

John Bollinger sums up the situation:

If you own stocks you should stop wishing for the Fed to stop raising rates. I know this is counter intuitive, but the fact is that the periods AFTER the Fed stops raising rates are periods of sub par equity performance.

Why would that be? Well both the Fed and the equity markets are forward looking and if the Fed thinks it has strangled the economy sufficiently, the market is not one to argue. A quick check shows that the Fed typically stops raising rates well before the bottom is put in.

All we can do is look to the last increase in the sequence historically, and note that the record is not attractive. In the past, following fina rate increases, stock prices were generally weak, and occasionally dramatically so. Everyone is looking for a relief rally when the Fed finally says it’s done, and there may well be one, but I think the savvy investor will do well to consider selling that rally.