Well-regarded stock market technician of the 1950s-1970s Edson Gould’s (1902-1987) “three-steps-and-a-stumble” rule is on the minds of investors as we draw closer to the first Fed rate rise since June, 2006. Gould’s dictum has held up tolerably well since it was coined: it states that bull markets are derailed after the Fed raises rates three times in rapid succession. Looking back on the century since the Fed’s founding, Gould’s rule of thumb has worked in about two thirds of the cases where the rule was triggered. (It’s far from a precise timing tool; even in the cases where it has worked, it has been months early.)
All signs suggest that a rate rise is imminent. So, is it likely that Gould’s old rule will work this time? Should investors hold on to their positions up to and through the first rise, in the anticipation that the bull will continue to run until the third? Or should they lighten up their holdings ahead of the “inevitable” rise in September (or December) out of an abundance of caution (or panic)?
Is This Time Different?
There is at least one fundamental difference between the current looming Fed rise and all the other rises that have occurred since the central bank’s founding. This rise is coming at the end of eight years of unprecedented monetary policy -- an era during which policies that would once have been unthinkable have become so commonplace that markets tremble when they’re removed (such as QE).
Rates have been pinned near zero in the developed world in order to counter the huge deflationary impulse created by the 2007-2008 financial crisis. Central banks have essentially spent eight years creating liquidity to compensate for the liquidity that evaporated with the collapse in the derivative-laden shadow banking system. For now, we can say they’re winning, although inflation is not robust and the specter of deflation has hardly been banished. Abundant liquidity has bid up the value of many financial assets, feeding a wealth effect and slowly enabling the real economy to find a sure footing. The data we see suggest that even if the recovery has been anemic by historical standards, it’s real; and the Fed has indicated with as much directness as it can muster that it believes it’s time to take away the punch bowl soon.
However, its reason to take away the punch bowl is different now than it has been before. Typically, the Fed raises rates to cool an overheating economy. Even though we are fundamentally bullish on U.S. economic prospects from a macro perspective, we would hardly venture to say that the U.S. economy is presently in danger of “overheating.” Rather, we believe that what’s happening is that the Fed is preparing to “normalize” rates -- take them from incredibly low to extremely low -- because unless it does so, it will lack fundamental ammunition and policy tools to address the next crisis that occurs, whenever that may be.
With the Fed Funds Rate Pinned Near Zero, the S&P Has Roared
This difference alone -- a rate rise not to calm the exuberance and animal spirits of an economy that’s getting too rowdy, but just to do anything to get rates above zero -- explains both the Fed’s extreme caution, and the nervousness of investors as they prepare. Indeed, in some important ways, this time is different.
The situation calls to mind some of Gould’s less-well-known dicta: “The action of the stock market is nothing more nor less than a manifestation of crowd psychology… the market is shaped by human emotions.” Stocks aren’t valued, he believed, “because of any systematic evaluation of their real worth, but, rather, because of what the mass of investors think they’re worth.” These may also be especially worth remembering at the present juncture.
What It Means For Investors Now
We anticipate, first, that the coming regime of rate rises, whatever the pattern, will be an occasion for greater market volatility than in the past: the market will be more difficult to navigate. The choppy and directionless market that has prevailed this year may be a foretaste.
Second, in the immediate lead up to the first rate rise, and in its immediate aftermath, we anticipate a market correction on the order of 7 to 10 percent. The crowd psychology that Edson Gould correctly saw underpinning market valuations is more anxious -- not the robust psychology of an economy well into an upswing of growth and optimism.
Third, after a wait of two or three months without further rises, the bull market could resume. However, we caution that the Fed’s forward path is uncertain, and markets will remain anxious as that path unfolds.
Under these circumstances, we believe that stocks owned for their yield are dangerous. The stocks most likely to persevere in this environment will be fast growers -- for example, biotechs, which have enjoyed several years of outperformance. Although our long-term orientation is to buy “growth at a reasonable price,” we recognize that under some conditions, the market is driven today not by careful and reasoned analysis, but by emotion and psychology… and by computers, but that is a discussion for future letters. The conditions unfolding into the Fed’s liftoff from years of near-zero rates may be conditions like this. We will look for volatility as the first rise comes closer -- and may use that volatility as a buying opportunity. But like all sensible investors, we will be watching carefully to see how the Fed handles the normalization -- and how market psychology responds.
Investment implications: With the Fed funds rate set to rise soon for the first time after years of extraordinary and unprecedented monetary policy, we believe that market psychology will make for a difficult investing environment. This anxiety is compounded by the fact that these rate rises will not be, as they have usually been in the past, actions taken to cool off an overheating economy -- they will be actions taken simply because without them, the Fed will have no ammunition in a future crisis. We anticipate a correction in the lead-up to and aftermath of the first rise -- but believe that after two or three months, the bull market could resume. Under these circumstances we would not own stocks for their yield, but would prefer highly valued, high-growth companies such as healthcare, biotech, tech, restaurants, regional banks, and cybersecurity.
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