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December 19, 2005

What Happens When the Fed is Finished?

John P. Hussman, Ph.D.
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With the S&P 500 at 19 times peak earnings – a level which has rarely delivered satisfactory long-term returns – investors are looking for a “story” to support continued bullishness. After all, the holiday seasonality argument is a bit long in the tooth.

So attention has turned to the prospect that the Fed has finished, or is just about to finish, its tightening cycle. Isn't that alone a great reason for bullishness here?

Well, not so fast. As it happens, there have been 13 tightening cycles since 1950 where the Fed has raised rates at least twice. In the six month period following the last hike of the cycle, the S&P 500 has delivered annualized total returns averaging 2.47% over the following 6 months, 5.06% over the following year, and 8.55% over the following 18 months. All figures are on a monthly closing basis.

In other words, the market's return has actually been sub-par for a reasonably long period following the final hike of a rate tightening cycle. Now, if we look ahead to the first cut of a new easing cycle, things are definitely more interesting. Historically, the Fed tends to start new easing cycles well into established bear markets, and not surprisingly, the subsequent returns have been quite good on average. Following the first cut of a new easing cycle, the S&P 500 has delivered annualized total returns averaging 23.01% over the following 6 months, 21.18% over the following 12 months, and 22.12% over the following 18 months.

Well then, all we've got to do is wait for the first sign of slight concern. Surely Bernanke will give the market a little jolt by easing rates a bit, don't you think? Then we've got it made. And if we know now that we'll have it made then, why not just stay bullish?

Unfortunately, it's not that simple either. In fact, if you parse the statistics based on the starting level of valuation when the last hike or the first cut was made, something profound happens. The results line up decidedly along valuation lines.

For example, about half the Fed reversals from tightening to easing have historically occurred from price/peak earnings multiples of 12 or less on the S&P 500. Even if you look at the periods following the final tightening, you can already see the impact of favorable valuations. In this situation, the S&P 500 has delivered annualized total returns averaging 6.41% over the following 6 months, 8.92% over the following 12 months, and 11.62% over the following 18 months. Note the improvement over the "unconditional" average outcomes (2.47%, 5.06% and 8.55% respectively).

But there's more. If you look at the first rate cut when the price/peak earnings multiple on the S&P 500 has been 12 or less, the market has historically responded with annualized total returns averaging 38.43% over the following 6 months, 30.95% over the following year, and 31.91% over the following 18 months. Those aren't even typos.

From the standpoint of our own discipline, it's not surprising that when favorable valuation meets favorable market action (even if you restrict market action to Fed-controlled rates only), you get some amazingly strong outcomes.

There is, of course, a flipside to that story. If you look at periods where the price/peak earnings multiple was 16 or higher on the S&P 500, the final rate hike of a tightening cycle was actually associated with losses on an annualized total return basis, averaging -7.18% over the following 6 months, -9.94% over the following 12 months, and -5.87% over the following 18 months. Given the current multiple of 19 times peak earnings on the S&P 500, this would be the relevant set of comparisons even if the latest rate hike was the final one (an apparent hope of some analysts, which runs counter to the Fed's language last week, where it noted “The Committee judges that some further measured policy firming is likely to be needed.”)

Still, isn't it just a matter of waiting for the first cut? Unfortunately, again the outcomes parse out on the unfavorable side. From a starting multiple of 16 or higher, the market's performance even after the first rate cut has been invariably tepid, with the S&P 500 achieving annualized total returns averaging -3.63% over the following 6 months, 5.47% over the following year, and 5.52% annualized over the following 18 months.

Suffice it to say that the hopes that a turn in Fed policy will be bullish for stocks, at these valuations, aren't all they're cracked up to be.

Market Climate

As of last week, the Market Climate for stocks continued to be characterized by unusually unfavorable valuations and unfavorable market action. It's important to recognize that our measures of market action have much more to do with broad market internals, spread behavior, price/volume action and industry and security group dispersion than they have to do with simple observation of the major indices. I neither attempt, nor believe it is possible, to “time” and “forecast” short term movements in the major indices with any reliability. The objective of our hedging is much more humble, but I think, very effective over the long run. That objective is to accept market risk in conditions that have generally been associated with high or at least acceptable average return/risk tradeoffs, and to avoid or hedge away market risk in conditions that have generally produced hostile tradeoffs, on average.

As a rule, once you've established a sufficiently diversified portfolio (if you haven't, the first step in risk management is to shut down your diversifiable risk), it's then optimal to vary your exposure to market risk more or less proportionally with the market's expected return/risk ratio. At present, the Strategic Growth Fund is fully hedged. Not net short (the dollar value of our shorts never materially exceeds our long holdings), but fully hedged.

Though I've been asked by several journalists, I continue to decline the opportunity to provide a “2006 forecast” for stocks. It's fair to say that I adhere to a general thesis that rich valuations tend to mute investment outcomes more often than not, and rich valuations coupled with unfavorable market action (assuming it continues unfavorable) is downright hostile. But as for forecasts, especially short-term ones, I have no idea. We'll align our investment position with the prevailing Market Climate and shift that position when sufficient evidence of a Climate shift emerges.

In bonds, the Market Climate continues to be characterized by unfavorable valuations and unfavorable market action, holding the Strategic Total Return Fund to a short 2-year duration, mostly in Treasury Inflation Protected Securities. The Fund also continues to hold somewhat less than 20% of assets in precious metals shares, and about 5% of assets in foreign currency denominated notes, primarily the Japanese Yen.

Peace, Love, Hope

And he took the child Jesus in his arms and praised God. – Luke 2:28

Merry Christmas.

Wishing you also a Happy Hanukkah, and a glad, hopeful New Year. With gratitude and appreciation, not only for your investment, but most importantly, for your trust, and for those of you I know personally, your friendship.

- John


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