Copyright © 2001 by Norman P. Poire. All rights reserved.

Most of us are familiar with the old Wall Street adage that it never pays to fight the Fed. Experience tells us that when the Federal Reserve Board accommodates the markets with lower interest rates, the prudent course is to shift assets into stocks. Restrictive monetary policy, on the other hand, signals us that it is time to take some money off the table.

With six discount rate cuts in as many months, the Fed has never in its history eased so frequently in such a short period of time. Yet the stock market, with all this wind in its sails, is struggling to simply tread water. Rather than blindly accepting our old saw on faith, I decided to see just how reliably it has performed over the long haul.

In its nearly 88 years, the Fed has pulled the discount rate trigger six or more consecutive times in just eight instances. Twelve months later, investors in equities found themselves anywhere from up +43.9 percent to down -28.1 percent. That substantial range suggests that the key to future returns does not rest entirely in the hands of the monetary authorities.

A closer inspection reveals that what the Fed governors do is less important than when they do it. If stocks happen to be near historic lows in valuation, aggressive easing by the Fed has been successful in prodding the stock market higher. When valuations are near historic highs, though, discount rate reductions on their best day have only managed to postpone the inevitable erosion in share prices.

To determine whether stock valuations are historically high or low, I use the simply constructed overbought/oversold indicator shown in the following chart. That figure shows the S&P 500 Index adjusted for inflation from 1915 to present. The entire price action over that period fits neatly within upwardly sloping parallel channel lines.

The channel is subdivided into four quartiles using three more parallel lines. These quartiles are labeled A through D from top to bottom. The point at which a 6^th consecutive rate cut was made is indicated on the chart with a small square. Next to the square is a number indicating the change in stock index value over the succeeding twelve months.

By adding the five rate-cut sequences to our database, the number of data points increases from seven to sixteen. These are displayed in the chart as circles followed by their one-year performance.

The only rate cut sequence of the 20^th century to fall within Quartile A began in late 1929. Over a twelve-month period share prices fell by more than 33.9 percent after the 5^th rate reduction and 28.1 percent following the 6^th cut. Stock values within quartile A are considered extremely overbought.

In quartile B, three series of rate reductions averaged a -16.6 percent twelve-month return while the average return in quartile C was a respectable +8.9 percent. Quartiles B and C represent overbought and oversold valuations, respectively.

Finally, the four most successful rate cut sequences in Fed history can be found in the extremely oversold quartile D. Their averaged return is a handsome +34.9 percent. When plotted against the other three quartiles, it becomes readily apparent that the Fed’s actions boost share prices only when stocks are oversold.

Equity values today have pushed into extremely overbought territory for the first time since the 1960s. At these valuations, history suggests that six rate cuts by the Federal Reserve are not reason alone to mortgage the house and leverage into stocks. Indeed, the prudent investor should not be surprised to find the S&P 500 Index lower a year from now — perhaps a good deal lower.

If you’re hopeful that the sheer swiftness of the Greenspan cuts will rescue stock prices, history is not securely in your corner either. The second most aggressive easing cycle ever came on the heels of the Crash of 1929 when rates fell six times in eight months. It was the only other time in history that rates were slashed six consecutive times while stocks were in either Quartile A or B.

The Fed in those days was sparing no effort to restore one of the great bull markets of all time. The years leading up to 1929 were filled with optimism for most Americans who were witness to technology-driven productivity gains, low inflation, and a falling federal debt. The Roaring Twenties was a time of rampant speculation in stocks led by the high-tech industries of the day: automobiles, radio, and electric household appliances.

When the bubble burst, no amount of monetary easing could stem the tide for long as the stock market trended lower for twenty years. The clear lesson of that era: there are times when it pays to fight the Fed.

Posted July 2001

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