“Don’t Fight The Fed”
“Don’t Fight The Fed.” But, unfortunately, that mantra has remained a “call to arms” of the financial markets and media “bullish tribes” over the last decade.
Armed with zero interest rate policy and the most aggressive monetary campaign in history, investors elevated the financial markets to heights only rarely seen in human history. Yet, despite record valuations, pandemics, warnings, and inflationary pressures, the “animal spirit” fostered by an undeniable “faith in the Federal Reserve” remain alive and well.
Of course, the rise in “animal spirits” is simply the reflection of the rising delusion of investors who frantically cling to data points that somehow support the notion “this time is different.” As David Einhorn once stated:
Is this time different? Most likely not. Such was a point James Montier noted recently,
While the “bulls” are adamant, you shouldn’t “fight the Fed” when monetary policy is loose, they say the same when it reverses. Such got evidenced by Fisher Investments arguing rate hikes are NOT bad for stocks.
Fisher does “mental gymnastics” to suggest the sell-off in 2018 was due to forces other than the Fed. However, what reversed the “bullish psychology” was evident.
That sharp sell-off in the chart above started following that statement from Jerome Powell. Why? Because even though the Fed had already started hiking rates previously, the comment suggested much tighter policy to come.
What reversed that “bear market psychology” just two months later? The Fed’s reversal on their “neutral stance.”
By the summer of 2019, the Fed’s interest rates returned to ZERO.
Why did the market rally?
Never Fight The Fed
They are. It is just a function of timing between the first rate hike and when something eventually breaks the “bullish psychology.” As we discussed previously:
Fisher is correct that rates may not impact the financial markets in the short term. However, most of the gains got forfeited in every instance as interest rates slowed economic growth, reduced earnings, or created some crisis.
Most importantly, a much higher degree of reversion occurs when the Fed tightens monetary policy during elevated valuations. For example, beginning in 1960, with valuations over 20x earnings, the Fed started a long-term rate-hiking campaign that resulted in three bear markets, two recessions, and a debt crisis. The following three times when the Fed hiked rates with valuations above 20x, outcomes ranged from bear markets to some credit crisis needing bailouts.
Yes, rate hikes matter, and they matter more when there are elevated valuations.
“I Fought The Fed, And The Fed Won“
The primary bullish argument for owning stocks over the last decade is that low-interest rates support high valuations.
The assumption is the present value of future cash flows from equities rises, and subsequently, so should their valuation. Assuming all else is equal, a falling discount rate does suggest a higher valuation. However, as Cliff Asness noted previously, that argument has little validity.
The problem for the bulls is simple:
Either low-interest rates are bullish, or high rates are bullish. Unfortunately, they can’t be both.
As noted, rising interest rates correlate to rising equity prices due to market participants’ “risk-on” psychology. However, that correlation cuts both ways. When rising rates reduce earnings, economic growth, and investor sentiment, the “risk-off” trade (bonds) is where money flows.
With exceptionally high market valuations, the market can remain correlated to rising rates for a while longer. However, at some point, rates will matter.
This time will not be different. Only the catalyst, magnitude, and duration will be.
Investors would do well to remember the words of the then-chairman of the Securities and Exchange Commission Arthur Levitt in a 1998 speech entitled “The Numbers Game:”
You can fight the Fed, but eventually, the Fed will win.
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