Written by Sam Kovacs
Have you ever wondered what actually happens when the Fed cuts rates? While stock market pundits, myself included, have been tirelessly speculating on the pivotal moment of the rate cycle, how much have we truly examined the aftermath?
In this article, I'll look into the historical patterns of stock market reactions following rate cuts, and try and place the current market in a historical archetype by asking tough questions like: Are we in a bubble? If yes, will it burst any time soon? Are we headed for a recession? Are we on the brink of massive technological change.
Sounds good? Let's dive in.
The Fed's long history of rate cuts
The Fed was established in 1913 by the Federal Reserve Act to provide the United States with a stable and secure financial system. Since its inception, monetary policy has been a key tool the Fed has used to influence economic conditions.
The Fed cut rates for the first time in 1921, and since then, has initiated 24 rate cut cycles.
On the chart below, you can see the evolution of the Fed Funds rate since 1955.
In its latest meeting, just over a week ago, the committee decided to maintain the federal funds rate at 5.25-5.50%.
The Fed's DOT plot showed a median expectation of just one rate cut by the end of 2024, revised down from three projected cuts earlier in the year.
While the Fed's stance appeared hawkish due to its commitment to controlling inflation, the projections indicated that rate cuts are coming.
Whether it is 3 cuts or 1 cuts this year, the dot plot plans for many more cuts in upcoming years.
And let me tell you: This is good news. I compiled the S&P 500's (SPX) (SPY) performance after the Fed started cutting rate in every instance they did so since 1921.
I went a bit over the top, tracking performance 1,3, and 6 months after the first cut, as well as 3, 5, and 10 years after. I used S&P 500 data from Robert Shiller's website. We'll get back to him later.
What can we take away from these results?
In the immediate month following a rate cut, the S&P 500 tends to be quite volatile, with an average return of -1.04% and a median return of -0.95%. With 13 out of 22 instances resulting in negative returns, it’s clear that the market often reacts unfavorably or hesitantly right after a rate cut.
But within a year, things start to look up, with the vast majority of the readings being positive. From 3 years after the cut onwards, only the worst market crashes (1929, 1937, 2001 and 2007) saw negative returns over the following 5-year period, and even 10-year periods if we take out the post 2007 cut from the list.
Statistically speaking, the market dips after the Fed cuts rates, then recovers. But like the quote Mark Twain popularized said:
There are 3 kinds of lies: lies, damned lies, and statistics
The idea here, to cite another popular statistics quote, is that:
Statistics are like bikinis. What they reveal is suggestive, but what they conceal is vital.
Or in other words, who cares that statistically things go up, if we're staring down the barrel of the next 1929? (I'll address whether I think we are in the later in this article).
So we should head to 19th century American statesman Henry Clay's advice:
Statistics may be used to support or undercut arguments, but it is never a substitute for thought.
So let's do some thinking. We're going to look at a handful of case studies of when the Fed cut rates and subsequent stock market performance was awful, then we'll look at a handful of case studies of when things went very well for markets after a rate cut.
Then we'll try and categorize today's market based on those archetypes.
Catastrophic returns after the Fed cuts rates.
In the past century, there are 4 post rate cut markets which should make investors shiver and fear the idea of investing in equities at all. They are the markets which followed the rate cuts in October 1929, March 1937, January 2001, and September 2007.
In October 1929, The Fed began cutting rates following the stock market crash in, a pivotal moment leading to the Great Depression. The stock market was extremely overvalued, with prices detached from economic realities. The subsequent collapse of banks due to defaults and withdrawals led to a severe contraction in credit. Widespread deflation reduced consumer spending and investment. The outcome was severe economic contraction, prolonged high unemployment, and a massive decline in asset prices. The market wouldn't recover beyond the 1929 high until 1957.
In March 1937, the Fed cut rates after a policy-induced recession hit the recovering economy post-Great Depression. The Fed had tightened fiscal and monetary policies in 1936-1937 in a move to curb inflationary pressures but ended up stalling the recovery. The economy slipped back into a recession as confidence was eroded, and spending fell. The misjudgment of the economy's strength and the subsequent rate cuts were insufficient to reverse the damage quickly. The market wouldn't recover beyond the 1937 high until 1954.
In January 2001, The Fed cut rates in a surprise move. How do I know it is a surprise move? Turns out, the 2001 internet is still online. Check out the following headline from CNN Money:
The Fed began cutting rates after the dot-com bubble burst in 2000. The collapse of inflated tech stock prices led to a significant reversal in wealth. The September 11 terrorist attacks in 2001 caused further economic uncertainty and market disruption. The September 11 terrorist attacks in 2001 caused further economic uncertainty and market disruption.
The outcome was a recession followed by a period of recovery that was eventually undermined when the housing bubble burst in 2007. It wouldn't be before 2014 that the S&P 500 would surpass its dotcom highs.
Which leads us to our latest case study: September 2007. The Fed cut rates in response to the emerging financial crisis driven by the subprime mortgage meltdown, which led to widespread mortgage defaults. Major financial institutions were heavily exposed to toxic mortgage-backed securities. Credit markets froze. A major liquidity crisis ensued. It would take 6 years for the market to beat its 2007 high.
That was a lot of stock market history to take in just a few paragraphs, but we're not done.
Brilliant returns after the Fed cuts rates.
We'll look this time at another 4 case studies, selected at various intervals, and after which stock market returns were good for all following time periods. We'll focus on the S&P 500 performance after rate cuts in June 1924, November 1960, September 1984, and July 1991.
In 1924, the Fed cut rates in response to a mild recession that began in 1923. The 1920s saw significant advancements in technology and productivity, such as the spread of electricity and the automobile industry. These lower interest rates helped stimulate borrowing and investment, and a consumer boom fueled the economy and led to the "Roaring Twenties".
In 1960, the Fed cut rates in response to a mild recession that started in late 1959. The cuts helped end the recession. Government spending on infrastructure and social programs, especially under President Kennedy’s New Frontier and later the Great Society programs under President Johnson, boosted economic activity. This era saw significant advancements in tech, notably in communications with the launch of satellites, a positive consequence of the race to the moon between the US and the Soviets.
The Fed's rate cuts in 1984 were intended to sustain the recovery from the early 1980s recession, which was induced by Volker's extremely high rates in the early 80s to beat inflation. Reaganomics played a big part in boosting returns in subsequent years: tax cuts, deregulation, and increased military spending under Reagan's policies contributed to economic growth. The rise of personal computing and advancements in technology sectors coincides with this period.
Finally, in 1989 while the economy was still growing, the Fed cut rates as it feared a slowdown. The rate cuts were somewhat preemptive to stave off a potential recession, leading to a softer landing and continued growth. The rise of the internet in the subsequent decade began to shape economic activity and market performance.
In what scenario is the current market?
There are similarities in the above positive and negative scenarios which would do well to take note of.
In every instance where the rate cuts were not sufficient to provide markets with support needed to prevent a crash over the next 5, the Fed's rate cuts were a reaction to a stock market bubble.
The bubble burst, and then the Fed scrambles to cut rates as the implications on the economy of the bubble bursting become apparent. This was the case in 1929, 2001 and 2009.
1937 was the outlier in my opinion, as the cuts were a result of the Fed tightening excessively too early, killing the economy in the process, and then cutting to try and adjust. Having World War 2 on the horizon likely kept the market depressed longer than it otherwise would have in this scenario.
In 1924, 1960 and 1989, the Fed cut rates to counter a mild recession or even as was the case in 1989 proactively to avoid a slowdown. 1984 was the outlier as it was the final set of cuts in the manic Volker reign of the Fed.
The bigger similarity here is that these cuts all coincided with a period of technological advancement which would change how we did business and how humans communicated.
The 20s brought electrification and automobiles at scale. The 60s brought satellite communication, fiber optics, integrated circuits and main frame computers. The 80s and 90s brought personal computers and the internet.
So to classify the current market, and the type of environment we're in, and therefore the outlook we can expect after the Fed's rate cut, we need to answer 4 questions.
- Are we in a bubble?
- And if yes will it burst any time soon?
- Are we heading for a recession?
- Is there a technological change which will have a huge impact in upcoming 10 years?
Are we in a bubble? And if yes will it burst? Will this technological change have a huge impact in upcoming 10 years?
The advent of A.I. is something we saw coming. It has been the motor of the current bull market. In January 2023, I wrote that "ChatGPT marks a turning point in the AI Revolution".
I offered 4 stocks for conservative dividend investors to buy:
We later ditched INTC when it cut the dividend.
Of the other 3, 2 significantly beat the index, and IBM was as good as the S&P 500 before dividends (better including dividends) when we started selling shares earlier this year.
Of course, they all did a lot less well than NVIDIA (NVDA) which is now the biggest stock in the S&P 500, increasing nearly 700% since January 2023, or Palantir (PLTR) which is up nearly 300% since then.
And it is these large gains in the leading AI stocks which have led many to ask if this was a bubble.
Robert Shiller, the Nobel prize winning economist, who notoriously called both the dot com bubble and the housing bubble, says a bubble requires 4 elements that culminate in "irrational exuberance":
- Excessive Valuations.
- Speculative Behavior
- Public Enthusiasm
- Media Hype
The economist shares his Shiller-CAPE ratio for the S&P 500 which uses adjusted average 10 year earnings for the S&P 500 to adjust valuations to the business cycle.
According to this ratio, the current reading of 35.7x has only been topped twice in history:
- in between February 2021 and February 2022.
- in between February 1998 and February 2001.
Looking back at history, you would think "oh no, above 30 is the danger zone", and you'd be correct. Except that...
Let's look at the chart more in detail. Throughout the 20th century, a Shiller PE above 20 was the danger zone. Above 25 was peak exuberance.
But in the 21st century, except for a short period in the early 2000s, and early 2010s, the Shiller PE has been nearly exclusively above 20, which does bring into question the utility of the chart.
Why could that be?
I see a handful of reasons that change the equilibrium. I'm sorting them by perceived impact:
- Lower interest rates: In the 21st century, rates have overall been much lower than in the 20th century. This takes money out of bonds and into equities. Think about it, what's your bond exposure? If I was a 30-year-old in 1980, I'd probably have 30% bond exposure using the old rule of your age is your bond allocation. Today I have 0.
- Institutional investors and ETFs: The stock market is owned in large part by institutional investors and passive vehicles. These tend to sell less than retail investors, which reduces the effective supply of stock, since much of it is just held by institutions.
- Corporate buybacks: More shares are bought back in the past two decades than ever, reducing the effective supply of shares, and thus keeping prices inflated.
Maybe this means that we're in the mother of all bubbles. Or the landscape has changed in a way that is keeping the equilibrium level of S&P 500's P/Es higher.
And even if we are in a bubble, the AI bubble would most resemble the Dotcom bubble, which let's not forget, got started in 1995 before culminating in 2000. Netscape IPO'd in 1995 at $28 per share and peaked that same year above $170. Yahoo IPO'd in 1996 at $13 per share and peaked in 2000 at $118.
In other words, the consumer oriented generative AI advancements of the past 2 years would place us along the lines of 1995-1997, which would suggest this dance is far from over.
Compare the P/E (TTM) valuations of some of the dotcom stocks at their peak in 2000 with valuations of AI related stocks right now.
Dotcom stock P/Es at peak:
- Cisco (CSCO): Above 100x
- Yahoo: Above 100x
- Microsoft (MSFT): Mid 50s
- Intel (INTC): Mid 40s
- QUALCOMM (QCOM): Above 100x
Current AI stock P/Es:
While Nvidia and Palantir are trading at eye-popping valuations, the rest of the impacted businesses are trading at valuations which are still far from a peak.
Robert Shiller hasn't publicly called the AI revolution a bubble yet, either. In fact, if you search for "AI Robert Shiller", you'll find articles detailing his 2018 intervention in Davos where he said:
"What we’re seeing is something unprecedented, which is the arrival of artificial intelligence, which has a big impact."
According to his intervention back then, the AI revolution will “almost surely lead to an increase in income disparities,” as “those who make and own the inventions” amass “immense wealth,” largely by “economizing on labor costs.”
Reading between the lines of the social implications suggests a vast increase in productivity, which always increases economic output. The distribution of that economic output is another question entirely. The point is AI is changing and will continue to change how we do business, how we compete, and how we consume. Get used to it.
The bigger difference again is that this time the key players are already immensely profitable. Nvidia trades at 75x last year's earnings, but only at 50x next year's earnings, which implies earnings growth of 50% over the course of the next year.
So to answer the 3 questions addressed above:
- If we are in a bubble, it's just getting started.
- Therefore, it is not likely to burst before the Fed cuts rates later this year.
- And yes, AI will change the economic landscape significantly.
Live by the sword, die by the sword, those are my bold forecasts.
Are we headed for a recession?
The final question to answer to place us in one of these archetypes is whether we are headed for a recession.
Answering this question would likely take another 10-page article, which I believe should be a topic for another day. I will point you to a good recent report of S&P Global indicating that recession probability remains somewhat elevated.
I'll side with Mohamed El-Erian here, saying that the economy is likely heading for a recession in 2025 if the Fed doesn't start loosening rates in the second half of the year.
In other words, we could be in for one of those policy induced recessions if they don't get their act together. Those can be dangerous. A soft landing or only a mild recession is still possible, and likely, if the Fed grows a pair and cut rates in September.
However, my experience with Jerome Powell is that he is reactive and not proactive. This was the case in reacting to inflation. I fear it will be the case with rate cuts. If he can get them going this year, we might just see a goldilocks scenario unfold, although probably not as good as if he had already cut rates this summer.
Conclusions and takeaways
Predicting economics is a fool's errand, but a game in which I partake.
Based on all the information above, I'd have to say that the most likely is that this 2024 rate cut will be stimulative to an economy which has proven resilient, and that with abating inflation, and growing investment in AI over upcoming years, it will fuel a bull market and good returns for years to come.
Of course, if proven wrong, I'll change my mind. But this is my base case.