Market Being Taken Out Back and Shot?

Just yesterday, I had to let go of a car I had driven for 9 years. At that age, and with 144,000 miles, the dealer will almost certainly not resell it. So I wondered, what will be its fate? Sold at auction? Packed into a container and shipped to a third-world country or maybe just taken to a junk yard and sold for scrap… the automobile equivalent of being taken out back behind the ol’ woodshed and shot, so to speak.

It makes me wonder, has the economy, and by association the stock market, been taken out back and shot by the U.S. Federal Reserve's most recent rate hikes that they now may be forced to reverse? Some history can be instructive:

It’s been said (in a variety of colloquial forms) that bull markets don’t die of old age, they are killed off by central bankers. And while that may not have been true every time, there are plenty of examples of when it was.

The shaded areas in the graph below represent recessions. Notice that in each case, the Fed funds rate had been increasing prior to the onset of a recession. There were differences in the timing and magnitude of the increases but no recession came without a rate hike of some kind.

The far right of the graph illustrates the rise of the Fed funds rate up from zero that has taken place in recent years. It obviously pales in comparison to Paul Volker’s dramatic rate hikes in the late 1970s to early 1980s that were needed to reign in runaway inflation, but it is a rise no less. A question worth asking is does it portend the onset of a recession?

It may not look like much, but this graph on Bloomberg.com caught my eye the other day:

Global PMI recently dropped below 50 after being smartly above 54 just over one year ago. Based upon feedback from purchasing managers around the world, manufacturing has fallen from expansion to contraction.

Here’s another one – economists’ opinion of recession probability within the next 12 months:

Some may say that economists’ opinions should be valued no more than any others, but the trend here can’t be denied. Barely more than one year ago, the collective probability of a recession in the minds of folks who study that kind of thing was less than 15% but is now more than 30%. Still low, but unquestionably growing.

From an investment point of view, should we really care about any of this? Maybe, but maybe not. The recession of 1958 was preceded by a period of rising rates not terribly dissimilar from that which has recently taken place. The only recession-related market volatility surrounding the 1958 recession was a small double-digit decline in 1957. The stock market didn’t decline much more than that in conjunction with the recession of the early 1960s.

That said, there were nasty bear markets in and around recessions in the early 1970s, mid-1970s, early 2000s and of course in connection with the Great Recession in 2008-2009. While recessions in the early 1980s and 1990s saw some market volatility, the declines weren’t as great as some of the other recessionary periods. A Fed funds tightening preceded the 1987 stock market crash, but the next recession didn’t start until July 1990.

At their most fundamental level, stock prices reflect the discounted value of companies’ future earnings. If as a result of recessionary forces, expectations for those future earnings suddenly become lessened, stock prices should be adjusted lower. So riddle me this – why does the stock market seem to rally on poor economic news?

Markets react to changes in fundamentals but they also react to changes in expectations, most notably changes in what is expected from the Federal Reserve. It has become crystal clear that Fed chair Jerome Powell has got the market’s back, which means that if things start to get shaky, an interest rate cut would be in the offing… a “Powell put,” you might say, is firmly in place.

The pricing in of this change in expectations has supported stock market ascension since the beginning of June. But this concept goes beyond expectations – falling rates allow for an expansion of the stock market’s aggregate price/earnings ratio, which contributes directly and positively to total stock market return. The greatest contributor to the stock market rally since March 2009, by a large margin, was thanks to price/earnings expansion, which was driven in large part by the Fed’s rate squashing quantitative easing (QE) programs.

So it seems that no one is being shot just yet. The stock market could continue higher in the near future as the more doveish Fed posture gets absorbed into the market’s collective psyche. But there really isn’t that much more market prodding that the Fed can do.

Changes in expectations can move markets in the near term, but fundamentals will have their day. The aforementioned QE was dramatic in its market-moving ability, but it represents just a portion of the secular rate decline that began some 38 years ago. It could be argued that the market’s return over that nearly four-decade span has skewed expectations to the overly optimistic for generations of investors.

From January 1928 through September 1981 (when rates peaked), the S&P 500 outperformed inflation by 4.6% annualized - a premium that seems about right. Since then, returns have bested inflation by 9% points, which almost certainly can’t be sustained.

I have no idea if interest rates will rise any time soon and it seems likely that a short-term decline is in the works, but the near 20 percentage point duration tailwind that supported excess returns for nearly 40 years is not in our future. If stocks provide a reasonable 5 percentage point premium above inflation in the years/decades to come, the nominal return would likely be around 7%... a number that could leave some investors short on their goals.

Alas, no need for despair. Opportunities to outperform and makeup the shortfall can be found. Not the least of these are high active share active management, low-cost smart beta, the monetization of the volatility risk premium and well-designed portable alpha strategies. Market returns may be lower than average in years to come, but solutions that can make up the difference are out there, and those who deploy them successfully may provide themselves with greater opportunities to achieve long-term investment goals.