The S&P 500 index briefly topped 3,000 for the first time today, driven by investor optimism that the Fed is on track to cut interest rates at the end of July.
A rate cut this month would be a pretty big deal, not so much because of its actual impact (a Fed Funds rate of ~2.15% rather than ~2.40% isn’t dramatic in and of itself), but because of what it would signify.
Consider that the last Fed rate cut was nearly 11 years ago — in dramatically different circumstances. That was the final cut of the Great Recession in December 2008, when the Fed dropped the Fed Funds rate to "the zero bound" of 0.00-0.25%. (That was also when the Fed started using a rate range rather than a specific rate, which they’ve done ever since, much to the annoyance of financial writers everywhere.)
A rate cut would also signify the reversal of the rate hike cycle that began in December of 2015 and stretched out for eight additional quarter-point hikes over the following three years. That culminated in the infamous December 19, 2018 "final" hike that sent the stock market into a deep correction.
It’s fairly shocking how much the Fed’s economic viewpoint has changed over the intervening 6-7 months. At the end of 2018, they were still projecting strong growth and more rate hikes indefinitely. In fact, it was precisely this reiterated expectation of future rate increases that caused the market to sell off so sharply.
Fast-forward to today, and while the Fed is still talking about "solid" economic growth and "strong" labor markets, they’re clearly not feeling confident, or rate cuts wouldn’t even be on the table at this point. How else to explain cutting interest rates when the unemployment rate is at historic lows and the economy seems to still be clipping along at a decent rate?
Here are three theories on that:
1. Presidential pressure. President Trump has relentlessly been after the Fed to lower rates. And ironically, Trump’s trade policy has helped produce the type of minor economic slowdown that has the Fed considering exactly that.
2. Unwinding a December mistake. One school of thought says that the Fed has recognized that it overtightened by at least one hike last year, so this wouldn’t be so much a new easing cycle as much as an erasing of that earlier mistake.
3. Nervous about future economic growth. I’d add "here in the U.S., and perhaps even more so abroad." In other words, while they’re talking a confident game (the Fed always does — they basically have to, as everyone would panic if they ever came out and said they saw a recession brewing), they’re trying to forestall the next recession by goosing the economy now.
Personally, I don’t put much stock in the first two. But I can definitely see the third being a distinct possibility. While the U.S. economy has continued to look pretty decent, the rest of the global economy doesn’t look so hot. Past Feds have vigorously maintained that they don’t act on behalf of the rest of the world, but there’s a reasonable self-interest argument to be made that if the global economy is teetering on the edge of recession and you’re the central bank in charge of the currency that the bulk of global trade is conducted in, it may make sense to give the accelerator a nudge sooner rather than later. I’m not arguing that’s what they should do, just that I can imagine that entering their thinking.
Meanwhile, the battle of forecasters over the likelihood of future recession remains vigorous. For every economist pointing to scary signs of impending doom (see these two charts from David Rosenberg for a couple of compelling examples), there’s another saying things aren’t that bad and could even be improving. But if you need a reminder to be skeptical of anyone’s forecasts on these matters, look no further than the Fed’s own 180-degree reversal over the past six months.
What happens next?
As frustrating as it is, there’s simply no way to know where the market goes from here.
On the one hand, the stock market absolutely loves rate cuts — it immediately rallies every time the idea is seriously considered. The immediate pivot from May’s lousy pullback to June’s boom was 99.99% due to the Fed publicly stating that they were considering rate cuts once again. One day the market is diving, the next it’s soaring. We’ve seen this movie before, as it was exactly the same story last December/January when the Fed pivoted from hiking to plateauing. And if investors get both of their wishes — rate cuts and a reaccelerating economy, there’s no telling how high the market might go.
(There’s some precedent for this idea, as the Fed cut rates in 1995 in what was largely viewed as a correction of a damaging hike the prior year. The market was already at all-time highs at that point and continued to rise at a rapid clip for years after that.)
But on the other hand, historically it hasn’t tended to end well for the market when the Fed ends an extended rate hiking cycle and begins cutting rates. Initially, there’s usually a "bad news is good news" reaction as poor economic news translates into rate cuts that boost the market. But ultimately, these policy reversals (from raising rates to cutting them) happen for a reason, and that reason is usually that the health of the economy is worsening. Eventually, this means falling company earnings, and when that trend picks up steam the stock market rolls over and heads lower. Remember that the Fed always cuts rates aggressively as bear markets gain traction — there is always a point where economic reality trumps Fed efforts to stimulate via rate cuts.
Today there’s just not enough solid information to say definitively whether the economy is heading for a recession in the next several months or not. Thankfully, while we’d sure love to know that answer, we don’t have to figure that puzzle out in order to be successful investors. SMI’s strategies are trend-following, not trend-predicting. Yes, we’ll end up giving back some of our late cycle gains when the market does eventually roll over. But we’ve got safeguards built into both Upgrading and Dynamic Asset Allocation that historically have kept those losses from getting too large.
And perhaps the biggest benefit of these types of market-driven (as opposed to prediction-driven) strategies is we keep our money at work until the market’s actual price trends break down to the point that our systems tell us to exit. There’s no risk that we’re going to get way too conservative years ahead of the eventual bear market, as there is when an investing strategy is based on a future market/economic prediction.
That’s more important than most investors realize. As Peter Lynch (former Fidelity Magellan manager and investing legend) once said, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” Defensive systems such as SMI uses are as much about keeping us invested during the periods prior to bear markets as they are about what happens in the bear markets themselves. That won’t necessarily show up in a comparison of returns, but it’s a significant factor nonetheless.
