The Investment Rate Warns Of Recession

Includes: DIA, IWM, QQQ, SPY
by: Stock Traders Daily

There is an old saying on Wall Street, "don't fight the Fed." This implies when the Federal Reserve is easing monetary policy that investors should not go against the grain and buy the market instead, but conversely when the Federal Reserve is tightening that investors avoid trying to buy the market as well. In 2006 I conducted a study that compared this philosophy in both tightening and easing cycles, and what I discovered surprised many people then, but the comparisons to today may surprise even more people now.

First of all, in normal economic cycles, prior to 2008, when the Federal Reserve actually could adjust interest rates to affect monetary policy, they were doing it based on the health and relative strength of the economy. The economy went through cycles, sometimes it was stronger than others, our stock market went through cycles as well, but at all times, even during the Internet debacle, our overall economy could stand on its own 2 feet. The viability of future growth may have been questionable from time to time, but underlying economic activity was still able to sustain itself.

It started in 1981, but through the end of 2007 our economy was in the third major up period in U.S. history according to one of the most accurate leading longer-term stock market and economic indicators ever developed, The Investment Rate. The Investment Rate identified the conditions that existed even after the Internet debacle as being within a naturally positive economic cycle, and with that the economy, even though it went through occasional setbacks, was still sound enough to support itself.

Therefore, changes to monetary policy, changes to interest rates, were made based on the conditions that existed at that particular moment, and if the economy was too strong they tightened, but if the economy was too weak they eased monetary policy instead. Conceptually, if the Federal Reserve is easing monetary policy because the underlying economy is weak investors should expect weak stock market conditions too, and that is exactly what happened prior to 2008. When the Federal Reserve engaged easy monetary policies by lowering interest rates, during the cycle in which they were lowering interest rates the stock market came under pressure.

On the other side of the coin, when the federal reserve engaged in tight monetary policies prior to 2008, when they increased interest rates they did so because the economy was too strong, and during those tightening cycles the stock market performed quite well. Essentially, because the economy was strong and even though the Federal Reserve was trying to stand in the way of it getting too strong, the stock market reacted positively during tightening cycles.

The adage of don't fight the Fed was not what it appeared to be prior to 2008, investors should actually have gone against the Fed then, but that may be completely different today. The Investment Rate told us that we were in a natural upward sloping positive economic cycle then, the economy could stand on its own 2 feet, and investors could comfortably assume that the reason monetary policy was changing was due to weakening economic conditions or conditions that were stronger than the Federal Reserve may have liked, and the stock market reacts to conditions like that. Inflation is obviously part of this equation, but economic conditions are the focal point and always have been.

Even after 2008, economic conditions have been the focal point, but material changes have also happened. In December 2007 the end of the third major up period in U.S. history, the one that began in 1981, came to an end according to the Investment Rate. The end of that upward sloping period also brought the beginning of the third major down period in U.S. history. As a result, the underlying conditions in our economy are different today than they were even during the Internet debacle. The underlying conditions in our economy today are deteriorating on a naturalized basis, where before they were actually improving on a naturalized basis year after year.

The difference here is very important to recognize, and it leads us to a determination when we reconsider that old adage of not fighting the Fed. During upward sloping cycles in the Investment Rate changes to interest rates gave us an indication of market direction as noted above, but in this downward sloping cycle, with interest rates at virtually zero and monetary policy based solely on capital infusion, the playing field has changed.

Not only is the economy deteriorating on a naturalized basis and therefore not able to stand on its own 2 feet, but it is the infusion of capital by the Federal Reserve that has kept this economy afloat. Although the adage of not fighting the Fed was contrarian in the past, it may be quite parallel today. When the Federal Reserve is infusing capital into the system it creates artificial interest in asset prices, and in that way supports the economy, but it is all so supporting an economy that is deteriorating naturally. Therefore, during this third major down period in U.S. history according to the Investment Rate, in order to keep the economy afloat the Federal Reserve must infuse more and more capital into the system every year to offset the declining natural state of our economy.

Unfortunately, the Federal Reserve does not have the luxury of tapering monetary policy at all. If they do they will leave the economy to stand alone and in doing so the economy itself will revert to the mean, which is a substantially lower level according to what has been one of the most accurate leading longer-term stock market and economic indicators ever developed, the Investment Rate. The economy cannot stand on its own 2 feet without contracting, the Federal Reserve cannot taper stimulus policies because the economy will contract measurably, and therefore the adage of don't fight the Fed is not what it was prior to 2008.

Before 2008, if monetary policy was easy we knew the economy was weakening and that told us to avoid the market. If monetary policy was tight, that meant economic conditions were strong and we should be buyers, but in today's environment because monetary policy is now based on capital infusion that old adage has turned on its head. We can see that capital infusion has supported asset prices, some would argue it has driven the stock market and housing back into bubble territory, but the economy as it stands today and as a direct result of that capital infusion is dependent on a consistent flow of stimulus from the federal reserve; anything less would be detrimental.

If the Fed begins to tighten, or taper in this case, it will be removing the lifeblood of our economy and what we knew to be true prior to 2008 will no longer be valid. This time, don't fight the Fed will mean sell everything, including housing, stock market investments, businesses that cannot sustain a recession/depression, and any other asset class that might be dependent on new money to grow because the perception of new money will change considerably the moment the Federal Reserve takes their foot off the gas.

When I say sell everything I mean anything tied to the direction of the SPDR Dow Jones Industrial Average ETF (DIA), SPDR S&P 500 ETF Trust (SPY), PowerShares QQQ Trust, Series 1 (ETF) (QQQ), and iShares Russell 2000 Index (IWM), anything that has any dependence on economic conditions, and anything that will deteriorate like asset prices did in 2008.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: By Thomas H. Kee Jr. for Stock Traders Daily and neither receives compensation from the publically traded companies mentioned herein for writing this article.