“The Storm’s Coming Now”: Don’t Assume a Fed Pivot Brings Immediate Relief

More than anything else, what ultimately determines stock prices in the 2020s? Is it corporate earnings? That’s a contributing factor, no doubt, but it’s not the main driver of asset prices nowadays. Rather, it’s liquidity and Federal Reserve policy that moves the markets – and that’s not good news for overeager investors now.

They might think it’s good news, but a report from Bloomberg just gave hasty large-cap index-fund investors a reality check. Everybody and his uncle is waiting with bated breath for signs that Fed Chairman Jerome Powell will usher in a fresh wave of Treasury purchases and a return to ultra-accommodative central-bank policy.

Yet, it may be a case of “be careful what you wish for, because you might just get it.” Granted, it might be a while before the Fed pauses interest-rate hikes, and then a while longer before it pivots back to interest-rate cuts. A recent hotter-than-expected jobs report and Producer Price Index (PPI) reading certainly won’t encourage the Fed to flip to a pause-and-pivot any sooner.

Still, it’s inevitable that the unemployment rate will rise, stock valuations will cool off somewhat, and finally the Federal Reserve will tap the brakes on bond-yield hikes. Powell wants to see “some pain” in the economy and markets (that’s his phrase, not mine) first, but the switch to a policy pivot will eventually happen.

And when it does, euphoria will overtake the financial markets and everything will be rosy again – right? Not necessarily, and not even probably. Via Bloomberg, a research study actually shows that, historically speaking, central-bank switches from raising interest rates to lowering them are typically followed by stock-market drawdowns.

Courtesy: Bloomberg

This may be counterintuitive, but as they say, the data doesn’t lie. Jason Trennert, chief investment strategist at Strategas Securities LLP, studied monetary cycles and S&P 500 performance since the 1970s, and concluded that pivots to accommodative monetary policy often portended stock-market downturns.

That’s not what the bulls probably wanted to hear, but it’s the truth. Trennert’s research showed that, after the first interest-rate cut (which is what defines a “Fed pivot”), the S&P 500 declined in all but one of the previous easing cycles. And we’re not talking about tiny drawdowns here: on average, the S&P 500 fell 24% after the first rate cut before finding a bottom.

“In many instances, the hopes of a recovery in stock prices lies with the expectation of a Fed ‘pivot’ in monetary policy,” Trennert commented. However, Trennert suggested that investors betting on a dovish Federal Reserve should reconsider their ultra-bullish positions.

As the old financial-market saying goes, hope isn’t a strategy. Nonetheless, legions of investors are hoping and praying that Powell and the FOMC will give traders the green light to buy large-cap stocks with both hands. However, there may be no “Powell put” and no Santa Claus rally this year.

The problem is that the stock-market rally following the COVID-19 crisis in 2020 and 2021 was so swift and powerful, that new traders got a dose of beginner’s luck. Everybody’s a genius during a bull market, or at least they think they are. 2022, it seems, gave many amateur investors their first experience of a prolonged bear market, though this bear market’s been relatively mild so far.

Courtesy: Bloomberg

Those same amateur traders have been buying up stocks despite multiple indications that share prices have more room to fall. The bond market, which is generally more sophisticated than the stock market, has sent warnings in the form of yield-curve inversions, which tend to precede recessions.

Thus, we see brief S&P 500 rallies that are at odds with the bond market, where long-dated Treasury yields are falling below short-term debt yields. Ask yourself: between the stock and bond markets, which one is “telling the truth,” and which one is likely to get trapped?

Amid this unsettling backdrop, Rich Weiss, chief investment officer for multi-asset strategies at American Century Investment Management, warns that a moment of reckoning is overdue for bulls obsessed with Fed rate policy. They’re “not seeing the bigger picture,” Weiss contends, and unfortunately for them, “The storm’s coming now.”

Moreover, Weiss seems to suggest that an imminent market downturn could persist for a while. “Whether it’s going be a tropical rainstorm or a Category 4 hurricane is where people are betting. It’s just a question of how severe and long lasting it’s going to be,” he cautions.

Sadly, most retail large-cap stock traders won’t heed Weiss’s warning or Trennert’s research. You, however, don’t have to succumb to “pivot hope” error that will take so many investors by surprise and, in all probability, incur preventable financial loss.