The Federal Reserve’s interest rate decisions remain the central focal point for markets. The timing and size of rate cuts are the subject of debate, but why the bank is cutting rates and how the full rate cut cycle might playout are far more important. The implications are not as straightforward as they might seem, and market expectations have shifted dramatically over the past year. What should investors know about how rate cuts have historically impacted the economy and markets?

The Fed typically lowers interest rates in response to a weakening economy, because makes borrowing cheaper for individuals and companies, while also increasing the incentive to spend rather than save. In theory, this boosts growth and supports the economy, especially during recessions and financial crises. Over the past few decades, the Fed made dramatic rate cuts during the early 2000s dotcom bust, the 2008 global financial crisis, and the pandemic in 2020.

The impact of rate cuts on the economy and market behavior is easily misunderstood. Lowering rates is intended to promote growth, but doing so during an economic crash means that a recession and bear market are likely to follow, or already underway. This means that rate cuts are historically correlated with poor market returns even though the rate cuts were in response to, rather than the cause of, these challenges.

Conversely, rate hikes are typically seen as slowing the economy, they often occur during economic booms and bull markets as the Fed slowly pumps the brakes. Thus, counterintuitively, rate hikes have historically corresponded to strong market returns.

Today, the Fed is not battling a sudden economic collapse or financial crisis but is navigating a period of slowing growth, decreasing inflation rates and a weakening but still strong labor market. In other words, the current situation is different from periods of emergency rate cuts. This is why the rationale for lowering rates matters when considering how they might impact markets in the months and years ahead.

Perhaps a more applicable example is the 1994-1996 rate cycle, when the Fed raised rates to combat inflation fears before lowering them again shortly thereafter. Periods like these are often referred to as “soft landings” since the Fed arguably managed to raise and lower rates without triggering a recession. There was initial shock to the bond prices – just as there was in 2022 – markets eventually responded positively to rate cuts once the economy stabilized.

The Fed’s dual mandate, as described in the 1977 Federal Reserve Act, is “to promote maximum employment and stable prices.” Today, this is interpreted as returning the inflation rate to 2% while ensuring the economy continues to grow steadily.

From 2009 to early 2020, inflation rates were below 2%, allowing the Fed to keep interest rates exceptionally low and corresponding with a strong job market. In contrast, the inflation of the past few years has required the Fed to make tough choices between price stability and jobs.

Fortunately, inflation numbers have improved since its peak in 2022. This doesn’t mean that prices are going back to pre-2022 levels, only that the speed that prices are rising (the dollar is being devalued) is much slower. The latest Consumer Price Index report showed that rates continued their gradual slowing in August, with the headline index rising 2.5% year-over-year. However, the Fed is hesitant to declare victory since core CPI, which excludes food and energy prices to measure the underlying trend, experienced an uptick to 3.2%. This was primarily attributed to stickiness in housing prices.

Monetary policy works with “long and variable lags.” Which means, if the Fed waits for inflation to be all the way back down to 2%, it may have waited too long. The cost of doing so would be an over-tightening of the job market. Thus, the recent softening in the employment data provides further support for reducing rates.

Given these economic trends, most economists and investors believe the Fed will cut rates a few times this year and throughout 2025. Bond yields have responded with the yield curve “dis-inverting” for the first time since the rate hike cycle began in 2022. This is because short-term interest rates, which are tied to Fed policy, have begun to fall while long-term interest rates, which are tied to economic growth, have not declined as much. This results in an “upward-sloping” yield curve which is often seen as positive for the economy.

Lower rates have been positive for both stocks and bonds across history. Bond prices move in the opposite direction of bond yields, which is why many bond indices have rebounded in recent weeks.

For stocks, lower interest rates mean that businesses have access to cheaper financing for investment and expansion. When it comes to the math of valuing companies, lower rates mean that future cash flows are discounted less, which can result in more attractive prices today. Of course, the market never moves up in a straight line, and investors should always be prepared for volatility.

The bottom line? Understanding why the Fed is cutting rates and the environment surrounding the moves is as important as the policy moves themselves. Currently the environment is slowing, but still positive economic growth, and falling inflation rates. If that remains true, it would be positive for capital markets.

Wyatt Swartz

Tuesday September 17th, 2024

A few weeks ago, I wrote a newsletter outlining the current mathematical challenge facing US stocks. To summarize: US stocks are unfavorably priced relative to history, US stocks are unfavorably priced relative to projected future earnings, and US stocks are unfavorably priced relative to bonds (& other fixed income securities).

Since that writing, stocks had significant declines with a strong rally this week.

Given circumstances, portfolio adjustments should be considered (in some cases already implemented). Any moves are designed to provide some level of defense should we see declines in stocks, but still capture the majority of the upside if markets rise.

This conversation is not relevant to all investors, or all investment accounts. Let’s establish where this is relevant.

1. Taking Withdrawals or Nearing Time (Retired & near Retirement) – Investors consistently taking withdrawals or nearing the point they will be.
2. Non-retirement Funds – Many investors have liquid, taxable investment accounts with different goals/objectives from their retirement funds.
3. Market Fatigue – Markets went on positive tear 2009 to 2020, during which volatility remained low. The 2020s have been a much more challenging environment for investors. 2022 was especially hard for retired investors, because we experienced a bear market in stocks and bonds. Rather than putting the car in park, sometimes investors need to take the foot off the gas a little. Better to get there 5-minutes later, than not get there.

2009 to 2020 was a very strong period for stock returns, and it was a period of extremely low interest rates. This made fixed income assets generally unappealing and led to the term “TINA” when describing the market environment, which stands for: There Is No Alternative. The implication was that investors were either in stocks or not invested, because fixed income was not providing a meaningful return above cash.

The world is different now. Fixed income assets can give investors meaningful positive returns, while having much lower short-term volatility than stocks. One might say that the 60/40 portfolio is back! Wall Street has described the situation as a “TARA Market,” which stands for: There are reasonable alternatives. Over the long-term stocks will continue to have superior returns vs. fixed income assets, but they aren’t only game in town anymore.

Now if you are reading this, and my last newsletter and thinking “how can we play defense if stocks take another downward tumble,” then see our below.

1. Increase Fixed Income Holdings – Meaningful returns with lower volatility.
2. More Active vs. Passive Holdings – Active funds have been unfairly treated over the last ~15-years. While it is true that in any calendar year only about half of active funds outperform their stated benchmark, they do better when/if markets go down.
3. Value/Dividends/Hedged – Owning stocks that are value priced, pay high dividends, or have some hedging mechanism may underperform broad indices in a rapidly rising market, but typically provide substantial cushion in down or flat markets. The goal here is to capture 60-80% of the upside, with only 40-60% of the downside.

Let me know if you have any questions. Talk soon.

Wyatt Swartz

Written November 3rd, 2023

At around 4,516 (today the S&P closed at 4,259) the S&P 500 is priced at 18.86x forward earnings. As seen below, the 20-year average is 16.77x, and 20.07x would represent a full standard deviation above average.

The earnings per share forecast is about $240 for the S&P in 2024 as seen in the chart below.

When you compare prior year forecasts, you will find they tend to be slightly more optimistic than reality in times of economic expansion. However, when recessions occur EPS typically decline below prior forecast. The median decline for earnings during recessions is 13%. That would imply S&P earnings of $209/per share.

We cannot say if there will be a recession in 2024, or if there is, that EPS for the S&P 500 will actually fall by 13% below forecast.

Taking into account that the gravitational force of the market pulls it up over time, we should still ask three questions regarding the US stock market.

1. Do we believe markets will mean revert back to historical ratios of price to earnings?
2. What is the probability for US recession in 2024?
3. If recession occurs in 2024, what do we expect EPS to be for the S&P 500 compared to our $240 forecast.

I call the above chart, “choose your level of optimism.” It shows that at a ~4500 starting point, if EPS were $250, and 18x P/E held true there would be a 0% gain. From there you can adjust to see the implied return based on EPS and P/E.

Example, if you expect $230 EPS, and for P/E to come down to 17x the implied return would be -13% (with 4500 as starting point, today’s level = 4258). I must apologize for outdated data; US stocks have fallen about 5% from mid-September when I started writing this. While the data is somewhat lagging, the concepts remain pertinent.

Markets of course are not as rational as the math I’ve presented above. There are many other forces that will impact the markets beyond the mathematics.

Thankfully, there are a number of attractive options for investors concerned with the math in US stocks. Please reach out if you would like to discuss.

To the W. Swartz & Co. private clients, I hope to send out an email next week summarizing actions we are taking to hedge against downside forces while continuing to participate in upside gains.

Sincerely,

Wyatt Swartz

Written October 5th, 2023