I have been increasingly vocal about my concerns about the stock market.
These concerns boil down to three:
- Extremely high stock valuations (which tend to mean-revert)
- Extremely high profit margins (which tend to mean-revert)
- Fed tightening (which often precedes sharp market declines)
Whenever I mention these things, some observers suggest that I can rest easy, because the Fed is not tightening yet.
For these folks, I have just one question:
What Fed are you watching?
As I see it, the Fed has been “tightening” for 9 months now, since it began to “taper” its monthly bond purchases last December.
Prior to that move, for more than a year, the Fed had been on hold — doing the same thing every month, neither loosening nor tightening.
And prior to that, for years, the Fed had been easing.
So to my mind, anyway, the Fed has been tightening for going on a year now.
The folks who are now worrying the Fed will someday begin to tighten are focused on the Fed Funds rate, because that’s the usual tool that the Fed uses to ease or tighten monetary policy. What these folks are missing, I think, is that Fed policy has been so extraordinarily loose over the past 5 years that the Fed long since moved beyond using the Fed Funds rate as its primary tool.
In other words, many years ago, the Fed pushed its usual Fed Funds accelerator all the way to the floor.
The car (the economy) was still sputtering, so the Fed then took the extraordinary step of firing up a special turbocharger (bond buying) to loosen even further.
And now, after a period in which both the accelerator and the turbocharger were running flat out, the Fed is powering down the turbocharger. Then, soon, it will begin lifting its foot off the regular old accelerator.
To argue that “tapering” is not “tightening” is to suggest that the Fed wasn’t easing when it started its extraordinary bond purchases in the first place. And that seems loopy.
So, beware, all you folks who are worrying that the Fed will someday begin tightening!
The Fed has been tightening for 9 months!
By The Way, Here’s What Happens To Stocks When The Fed Tightens
For the last five years, the Fed has been frantically pumping more and more money into Wall Street, keeping interest rates low to encourage hedge funds and other investors to borrow and speculate. This free money, and the resulting speculation, has helped drive stocks to their current very expensive levels.
But now the Fed is starting to “take away the punch bowl,” as Wall Street is fond of saying.
Specifically, the Fed is beginning to reduce the amount of money that it is pumping into Wall Street.
To be sure, for now, the Fed is still pumping oceans of money into Wall Street. But, in the past, it has been the change in direction of Fed money-pumping that has been important to the stock market, not the absolute level.
In the past, major changes in direction of Fed money-pumping have often been followed by changes in direction of stock prices. Not immediately. And not always. But often.
Let’s go to the history …
Here’s a look at the last 50 years. The blue line is the Fed Funds rate (a proxy for the level of Fed money-pumping). The red line is the S&P 500. We’ll zoom in on specific periods in a moment. But just note that Fed policy goes through “tightening” and “easing” phases, just as stocks go through bull and bear markets. And sometimes these phases are correlated.
Now, let’s zoom in. In many of these periods, you’ll see that sustained Fed tightening has often been followed by a decline in stock prices. Again, not immediately, and not always, but often. You’ll also see that most major declines in stock prices over this period have been preceded by Fed tightening.
Here’s the first period, 1964 to 1980. There were three big tightening phases during this period (blue line) … and three big stock drops (red line). Good correlation!
Now 1975 to 1982. The Fed started tightening in 1976, at which point the market declined and then flattened for four years. Steeper tightening cycles in 1979 and 1980 were also followed by price drops.
From 1978 to 1990, we see the two drawdowns described above, as well as another tightening cycle followed by flattening stock prices in the late 1980s. Again, tightening precedes crashes.
And, lastly, 1990 to 2014. For those who want to believe that Fed tightening is irrelevant, there’s good news here: A sharp tightening cycle in the mid-1990s did not lead to a crash! Alas, two other tightening cycles, one in 1999 to 2000 and the other from 2004 to 2007 were followed by major stock market crashes.
One of the oldest sayings on Wall Street is “Don’t fight the Fed.” This saying has meaning in both directions, when the Fed is easing and when it is tightening. A glance at these charts shows why.
On the positive side, the Fed’s tightening phases have often lasted a year or two before stock prices peaked and began to drop. So even if you’re convinced that sustained Fed tightening now will likely lead to a sharp stock-price pullback at some point, the bull market might still have a ways to run.
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