An investing axiom holds that it’s useless to “fight the Fed,” reflecting the popular view that the central bank’s actions alone are enough to keep equity prices rising.
But that isn’t true. The two most recent 50 percent-plus stock-market declines — in 2001-2002 and 2008-2009 — occurred while the Federal Reserve was swiftly lowering interest rates to spur the economy. So when are favorable monetary conditions helpful for stocks? Let’s take a closer look.
After drilling down into the data, we can say that monetary policy is most accommodating when either of the following conditions are present:
1. The federal funds rate, the discount rate or the 3-month Treasury bill are yielding less than they were six months earlier, or
2. The Fed lowers the fed funds or discount rate.
Now consider the past two stock-market collapses. The 2001-2002 dot-com bust was concurrent with lengthy and aggressive monetary easing, as shown in chart 1, below.
Along the same lines, chart 2, below, reveals that similar conditions were present during the 2008-2009 credit crisis. That’s right: Persistent monetary easing did nothing to prevent the 55 percent collapse in the S&P 500 that began just about five years ago.
Monetary policy was ineffective because the market declines were preceded by overly bullish euphoria.
But here’s the kicker: Easy-money policies cause financial asset bubbles, which ultimately result in market crashes. And as the charts illustrate, that’s precisely what happened in 2001-2002 and 2008-2009.
I’m not saying investors ought to ignore monetary policy. In fact, favorable monetary conditions have contributed to stronger investment returns — as well as smaller losses — in many instances since the 1940s. It means monetary policy is most useful in supporting positive economic trends as opposed to creating them.
|Easy-money policies cause financial asset bubbles, which ultimately result in market crashes.|
That’s why I’m concerned that investors have forgotten recent history. They think the Fed’s easy-money policies are a veto against financial risks. They think there’s a direct cause-and-effect link between loose-monetary policy and rising stock prices. But that’s not always the case.
In fact, favorable money policy has been most damaging to stock prices when the S&P 500 has fallen below its 200-day moving average and overvalued, overbought conditions are present. During most of those times in history, the future returns on stocks have underperformed Treasuries, often incurring steep losses along the way.
So the worst-case scenario is being invested in stocks when they come off overextended conditions and then break trend support. That’s not what I see today, but we are getting dangerously close.
To sum up: Favorable monetary conditions are not irrelevant. But they are also not omnipotent.
These are uniquely unusual times in which it’s prudent to construct a sound investment strategy. It requires careful consideration.
Please go to Money and Markets’ Facebook page for two big warnings about the stock market — one from 1972 that resulted in an epic decline and the other from only three months ago.