Investment Strategies: From Wall Street to Main Street Hingham MA

By Craig Hartnett of Hingham MA

With the economy in the late stages of this economic recovery that was further underpinned by the fiscal stimulus associated with the tax cuts and the labor force at full employment, the Federal Reserve has continued to raise rates. The rate hikes are being done more rapidly with 3 increases in 2017 and 3 so far in 2018 and another expected on December 19th. The Federal Reserve has now raised the Federal Funds rate 2% in total.

The Federal Reserve has also been doing quantitative tightening simultaneously (unwinding their quantitative easing by selling the bonds that were purchased to ease monetary conditions). When the Federal Reserve purchased $2.2 trillion in bonds from 2009 through 2014, this had the same effect on markets as if they had lowered interest rates by about 2.75%. The Federal Reserve planned quantitative tightening (balance sheet decline of $600 billion per year currently) would be equivalent to an increase in the Fed Funds rate of 0.75% or about three hikes of a quarter-point (0.25%) per year.

Therefore, the Federal Reserve has effectively raised rates / tightened monetary conditions by over 3% when the Fed Funds rate increases are combined with the quantitative tightening. By contrast leading up to the 2007/08 financial crisis and great recession, the Federal Reserve raised rates by 5.25%.

The 10 bear markets in U.S. stocks since 1955 have all been caused by the Federal Reserve raising interest rates in the later stages of the economic cycle by at least 1.37% which caused either a recession (8 times) or an economic downturn (2 times).
For the bear markets that did not precede a recession, the Federal Reserve raised interest rates by a much more modest amount. These two bear markets averaged 5 months as compared to 16 months for the bear markets that did precede an official recession.
The stock market is in a bear market.

The bear market is a result of the over 3% of monetary tightening the Federal Reserve has done along with the additional rate increases and quantitative tightening in December 2018 and 2019 (3-4 rate increases) the Federal Reserve had indicated it planned to do which would cause a recession.

Following the Federal Reserve meeting on December 19 and rate decision, I expect they will indicate much less tightening in 2019 than they previously had outlined. A reduction in the total amount of interest rate increases, will lead to an economic slowdown and make an official recession (2 quarters of negative growth) less likely to begin in 2019.
Based upon this expectation for the Federal Reserve to temper the total amount of tightening (and even ease rates as the next move after December 2018), the bear market will be more consistent with those that have preceded an economic slowdown and not a recession. These bear markets averaged 5 months in length and averaged a 22% decline.

In a bear market that preceded an official recession, the bottom for the stock market occurs after a longer period of time (almost 1.5 years form the top and after the Federal Reserve dramatically reduces interest rates).

The Russell 2000 index has already declined 20% into a bear market. The S&P 500 is down 13% from the peak in early October 2018.
In my November 5th 2018 commentary, I outlined that the end of the bull market is drawing close and Investors in the stock market should embrace a more conservative stance. The S&P 500 has declined 7% since then.

Investors should continue to maintain the conservative stance toward the equity market since under either scenario of a Federal Reserve induced economic slowdown or recession, there will be continued much higher volatility and potential further downside risks.
The strategy for investors in early 2019 will be driven by the future outlook for the Federal Reserve rate movements. Clarity on this will be provided in the statement following their meeting on December 19th and will determine whether the bear market is expected to be more modest in length and amount of the decline.

This is meant to provide perspectives on the stock market outlook and is not a recommendation from Craig Hartnett to investors in Hingham MA and the local community.