Do Federal Reserve rate cuts signal a bear market bottom? Here’s what the story says

What a difference a year makes! Last year was characterized by minimal equity market volatility, with S&P500 (^GSPC 2.46%) not retracing more than 5% at its peak. In 2022, all three major indices fell in a bear market, with the ageless Dow Jones Industrial Average (^ DJI 2.59%)S&P 500 and growth-oriented Nasdaq Compound (^IXIC 2.87%) plunging as much as 22%, 28% and 38%, respectively, from their all-time highs.

For one thing, double-digit percentage declines in the stock market have always presented a buying opportunity for patient investors. Still, it can be difficult for investors – especially new investors – to deal with the wild price swings of the bear market. People rightly wonder when and where the bear market will bottom.

Image source: Getty Images.

Here’s why investors are watching the Fed’s moves closely

Some investors believe that the Federal Reserve’s monetary policy can act as a surefire indicator of a stock market bottom.

As the US inflation rate hit a more than four-decade high of 9.1% in June 2022, the country’s central bank had no choice but to raise its target federal funds rate to the most aggressive pace in decades. As interest rates rise, access to cheap capital and demand for borrowing should decline. In other words, the Fed is deliberately holding back the US economy to keep high inflation under control.

The thinking of a select group of investors is that a pivot by the Fed from hawkish to accommodative monetary policy could give the green light to reinvest in equities. If interest rates were to stabilize or start falling, this would, in theory, signal the Fed’s intention to revive economic growth, especially among high-growth companies.

However, the country’s central bank does not seem ready to let go of the accelerator. As of September 21, the central tendency projection (i.e. the consensus forecast excluding the three highest projections and the three lowest projections for a given year) for the federal funds rate is 4.4 % to 4.9% in 2023 and from 4.1% to 4.4% at the end of 2022. For context, the target federal funds rate is currently 3% to 3.25%. This would imply a high probability of a 75 basis point rate hike in November, and at least another 75 to 100 basis points of future headline hikes before the Fed even thinks about rate cuts, which are currently expected to occur. produce in 2024.

Don’t expect a quick stock market bottom if the central bank changes its tune

Although rate easing is almost always viewed as a positive for equities, the Federal Reserve has a history of reacting to economic variables rather than proactively anticipating them. In other words, it’s usually late to the party when it comes to adjusting interest rates up or down. The runaway inflation we have experienced this year on the heels of historically low lending rates and a long period of quantitative easing (buying bonds and mortgage-backed securities) is testimony to this.

Table of Effective Federal Funds Rates

Effective federal funds rate data from YCharts.

Since the beginning of this century, investors have gone through four bear markets, including the current one. In each of the three previous bear markets, it took a long time for the stock market to bottom out after the central bank decreed the first rate cut in an easing cycle.

  • Less than a year after the bursting of the dot-com bubble, on January 3, 2001, the Fed began an easing cycle that would see the federal funds rate fall from 6.5% to 1.75% in about 11 months. . However, it took until October 9, 2002 for the stock market to reach its nadir. That’s a wait of 645 calendar days between the initial low and the actual low.
  • As the financial crisis began to take shape, the country’s central bank cut the federal funds rate from 5.25% to an eventual range of 0% to 0.25%. Although this rate cut began on September 18, 2007, the stock market did not bottom out until March 9, 2009, 538 calendar days later.
  • The Fed, once again, began to cut its target federal funds rate on July 31, 2019, with this round of easing bringing rates down from a range of 2% to 2.25% to 0% to 0.25 %. As the coronavirus crash bottomed out on March 23, 2020, we’re talking about a difference of 236 calendar days between the initial rate cut and the actual market low.

To be clear, there is no infallible indicator or metric that accurately predicts when bear markets will occur or precisely where they will bottom. But the data here clearly shows that Federal Reserve rate cuts are not a good predictor of stock market lows. Given that it typically takes several quarters for rate changes to have any tangible effects on the US economy, it makes sense that most market lows occur much later.

If current forecasts for the fed funds rate hold true and history repeats itself, a stock market bottom may not be predicted until late 2024 or well into 2025.

A person reading a financial newspaper seated at a table.

Image source: Getty Images.

Here’s why buying stocks now makes sense (even though a bottom may be years away)

Granted, that’s probably not the data you wanted to hear. But as noted, no indicator or metric is foolproof when it comes to calling stock market lows.

There is, however, a practical guarantee offered by Wall Street, and all it requires is patience from investors.

For some time now, the market analysis firm Crestmont Research has published rolling 20-year total returns, including dividends paid, of the S&P 500. For example, the rolling 20-year total return for 1936 would include the years 1917 through 1936 and counts for all dividends paid. This total return is then averaged over 20 years by Crestmont and expressed as an average annual total return.

Crestmont used its tools to analyze 103 individual 20-year rolling periods from 1919 to 2021. Its data shows that each 20-year rolling period produced a positive total return. The key point being that market timing matters a lot, far less time in the market. If you were to buy and hold an S&P 500 tracking index for 20 years, that’s a handy guarantee that you’ll make money.

Even though a long list of indicators and metrics suggest the stock market is far from bottoming, adding high-quality companies during the current bear market decline is a smart move for long-term investors. term.