One of the most strongly held beliefs of investors here is the notion that it is inappropriate to “Fight the Fed” – reflecting the view that Federal Reserve easing is sufficient to keep stocks not only elevated, but rising. What’s baffling about this is that the last two 50% market declines – both the 2001-2002 plunge and the 2008-2009 plunge – occurred in environments of aggressive, persistent Federal Reserve easing.
It’s certainly true that favorable monetary conditions are helpful for stocks, on average. But that average hides a lot of sins.
There are many ways to define monetary conditions using policy rates, market yields, and variables such as the monetary base or other aggregates. But given the strong relationship between monetary base/GDP and interest rates, these measures overlap quite a bit, and the results are quite general regardless of the precise definition. For discussion purposes, we’ll define “favorable” monetary conditions here as: either the Federal Funds rate, the Discount Rate, or the 3-month Treasury bill yield lower than 6 months prior, or the last move in the Fed Funds or Discount Rate being an easing. Historically, this captures about 52% of historical periods. During these periods, the total return of the S&P 500 averaged 13.5% annually, versus just 8.8% annually when monetary conditions were not favorable.
This is a worthwhile distinction, but it doesn’t partition the data enough to separate out periods where the average return on the S&P 500 was below Treasury bills. So historically, using this indicator alone would have suggested holding stocks regardless of monetary conditions. One might expect to do better by taking a leveraged exposure during favorable monetary conditions, and a muted exposure during unfavorable conditions, but this strategy would have invited intolerable risks. Strikingly, the maximum drawdown of the S&P 500, confined to periods of favorable monetary conditions since 1940, would have been a 55% loss. This compares with a 33% loss during unfavorable monetary conditions. This is worth repeating – favorable monetary conditions were associated with far deeper drawdowns.