The strongest stock market rallies after an initial interest rate cut have occurred during periods very different than today.

William Hester, CFA
March 2007
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The relationship between investors and the Federal Reserve is a bit like the one between parents and teenagers. When things are going smoothly, it's preferred that the Fed stay behind the scenes and out of the picture. But when trouble ensues, investors are quick to turn for help.

You can see this in the recent trading patterns of the S&P 500 and the implied rate of the Fed Funds futures contracts. They've shadowed one another since the market came off its high in February. On days the market has declined the expectations for a cut in interest rates have increased, and vice versa.

Investors are expecting a 25 basis point rate cut at the September meeting, and another one by the end of the year, according to futures prices. Rate-cut expectations may grow stronger over the next few months if weakness in the sub-prime mortgage market grows, job creation continues to slow, and the manufacturing indexes show more persistent contraction.

Even the expectation of a cut may bring optimism. That's because one of the most trusted investor axioms is "Don't fight the Fed." Investors believe that when the Fed begins to cut interest rates, stocks rally. And on average, that's been true. But when you parse the data on important metrics like valuation and growth expectations, some interesting patterns surface.

A portion of this research updates Dr. Hussman's What Happens When the Fed is Finished and Outside the Oval. The results below are based on weekly closing prices beginning in 1955, a slight change from the original analysis. Although the numbers differ slightly, the message is unchanged. The strongest stock market rallies after an initial interest rate cut have occurred during periods very different than today.

Since 1955 there have been 11 periods where the Fed lowered rates at least once after raising them multiple times. Average returns have been strong during these periods. Following the first interest rate cut, the S&P 500 has advanced at annualized rates of 23.9% over the following 6 months, 18.3% over the following 12 months, and 18.7% over the following 18 months. Segmenting the data by valuation quickly highlights the role that cheap markets play in affecting stock market returns. During periods where the S&P 500 price-to-peak-earnings multiple was less than 15, an initial rate cut was followed by annualized S&P 500 returns of 43.2% over 6 months, 26.1% over 12 months, and 25.4% over 18 months.

Good returns followed nearly every instance that a rate cut took place at low valuations. This is because the Fed often begins cutting rates only in the later portions of bear market declines. The Fed began easing rates in December 1974 when stocks were trading at 7 times earnings. Two more easing cycles began in 1980 and 1981, when stocks were trading at less than 9 times earnings. The 1990 easing cycle began when the S&P was priced at 12.5 times peak earnings.

In contrast, rich valuations have produced far more tepid returns. When the S&P 500 price-to-peak-earnings ratio has been above 17, the market's annualized return following the initial rate cut was -2.3% over the following 6 months, 5.9% over the following 12 months, and 6.2% over the following 18 months. Though there are fewer occurrences of rate cuts at higher valuations, they're also more varied.

Adding economic expectations to valuation criteria provides further insight into the variation in these returns. One way to measure these expectations is by looking at the spread between long-term Treasury yields and shorter-term yields. This spread gives an indication of the market's economic expectations, reflecting the outlook for demand growth, inflation, and Fed policy. Steep yield curves (long-term yields substantially above short-term yields) usually imply expectations for faster economic growth. A flat yield curve implies slower growth. Historically, an inverted curve has been a forecast of a contracting economy. The track record of the yield curve is good, too. Since 1960, an inverted Treasury yield curve has been among the most reliable indicators of an oncoming recession.

The chart below shows the average 6-month, 12-month and 18-month returns (annualized) following a first-time cut by the Fed. The two sets of bars on the left show the returns during periods where price to peak earnings ratios were less than 15 and in periods where the yield curve was either upward sloping or inverted. The two sets of bars on the right show both yield curve environments, but during periods where the price to peak earnings ratio was greater than 17.

From low valuations, average stock market returns have been strong in both periods where the yield curve was upward sloping and where it was inverted. But overvalued markets have been more sensitive to economic growth expectations. When the price to peak earnings ratio was above 17 and the yield curve was inverted, stocks suffered annualized losses of -6.9% over the following six months, -4.4 % over the following 12 months, and -9.3% over the following 18 months. This includes the losses incurred during the 2000-2002 bear market, as well as the bear market beginning in 1968, where annualized returns were -0.4% over the following 12 months and -3.4% over 18 months. The chart above displays a basic fact of investing. Low valuations are more forgiving of whatever economic outcomes may occur.

Poor economic performance following inverted yield curves is one part of the explanation for these results. Another is the direction that long-term bond yields eventually take. When the Fed lowers its overnight rates, the expectation is often that long-bond yields will follow, lending a boost to stock valuations. But the data on this is mixed, especially following yield curve inversions. In cases since 1960 where the slope of the yield curve was inverted, 10-year bond yields actually rose following the Fed's first rate cut - an average of 43 basis points over the next 12 months and 15 basis points over the next 18 months. In only about half the occurrences were long-bond yields lower a year later.

Long-term Interest Rates

The strong stock market returns following an initial Fed rate cut have historically come from some combination of low valuations, an upward sloping yield curve, and falling long-term yields (with low valuation trumping the others). The S&P currently trades at 17 times peak earnings, so the low valuation component is missing. And the yield curve has been inverted since July. Will stocks get a boost from lower long-term rates?

Two trends are worth noting here. One is the relation between economic growth and the level of bond yields. As Jim Bianco has done, we can compare the year-over-year change in nominal GDP with the 5-year Treasury yield, which have historically tended to move together over time.

The correlation of these two rates increased throughout the 20-year period of disinflation beginning in the early 1980's. The two rates widened in 2003 inflation and short-term interest rates remained depressed even while the economy recovered strongly.

The two rates have recently converged as the economy has slowed and interest rates have trended higher. About 100 basis points still separate the two. To equate the two at the current level of the 5-year note, nominal GDP would need to fall a full percentage point. But the data suggest that the market normally prices yields slightly above the economy's nominal growth rate, partially as insurance against getting the inflation forecast wrong. In that case the economy would need to slow two full percentage points, to a nominal growth rate of 3.6%, to match the longer-term average.

Current expectations are more optimistic than that. Economists expect nominal GDP to be 5.4% in this year's fourth quarter, according to the Philadelphia Fed's Survey of Professional Forecaster survey. Given that inflation is approaching a 3% annual rate, nominal growth rate of 3.6% would put the economy on the cusp of a recession. For comparison, year-over year nominal GDP bottomed at 2.7% during the 2001 recession. In 1991, the nominal GDP growth rate hit a low of 2.9%. So it seems that bonds are already priced with the expectation for the economy to slow substantially.

Inflation Surprises

Inflation trends are also worth watching here. Specifically, it will be important how the data comes in relative to expectations. This week's inflation surprises in the PPI and CPI were less of an aberration than a continuation of a trend of inflation surprises that began in January on a variety of measures. The blue line in the chart below shows an advance decline line based on inflation surprises. A rising line denotes inflation data that was reported higher than the median economist's estimate for a given report (for example, the ISM prices paid indices, the CPI, the PPI, and so forth). The orange line is the implied inflation rate, based on the difference between the 10-year nominal Treasury yield and the yield on 10-year inflation-protected Treasuries.

Inflation expectations and inflation surprises have tracked one another closely over the last couple of years. Brief periods of inflation surprises are not out of the ordinary. Surprises crept up last summer before subsiding later in the year. You can see in the chart that the bond market (red line) initially ignored January's surprises (blue line) as temporary. This week's surprises finally prompted a reaction.

Since late last year bond investors have mostly been siding with Bernanke's view that inflation will slow along with the economy. This view may turn out to be correct. But the outcome of at least a mild decline in the inflation rate seems to be already priced into bonds. If inflation surprise trends continue higher, the bond market - and the Fed - may eventually have to adjust their views.

In any case, investors should keep in mind that the stock market's reaction to Fed cuts has historically been dependent on other conditions such as valuations, economic expectations and the slope of the yield curve. The belief that rate cuts strongly benefit the stock market is based on conditions that don't match the present very well. It's possible that a Fed cut might help the stock market later this year. But given current conditions, history doesn't support much risk-taking based on that hope.

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The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

Prospectuses for the Hussman Strategic Growth Fund, the Hussman Strategic Total Return Fund, the Hussman Strategic International Fund, and the Hussman Strategic Dividend Value Fund, as well as Fund reports and other information, are available by clicking "The Funds" menu button from any page of this website.

Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-looking statements based the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a guarantee of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. Actual returns may differ substantially from the estimates provided. Estimates of prospective long-term returns for the S&P 500 reflect our standard valuation methodology, focusing on the relationship between current market prices and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle (see for example Investment, Speculation, Valuation, and Tinker Bell, The Likely Range of Market Returns in the Coming Decade and Valuing the S&P 500 Using Forward Operating Earnings ).