The Markets Are Front-Running The First Rate-Cut

Authored by Lance Roberts via RealInvestmentAdvice.com,

In October, the markets were down 10% from the July high, bond yields were touching 5%, and talk of a coming recession was rampant. What happened?

Interestingly, a Wall Street axiom says, “Sell the last Fed rate hike.” The reason is that when the Fed starts cutting rates, it is due to the onset of a recession, a bear market, or a financial event. At that point, as shown below, the markets are repricing for lower expectations of earnings growth rates and profitability.

As Michael Lebowitz noted previously in “Federal Reserve Pivots Are Not Bullish:”

“Since 1970, there have been nine instances in which the Fed significantly cut the Fed Funds rate. The average maximum drawdown from the start of each rate reduction period to the market trough was 27.25%.

The three most recent episodes saw larger-than-average drawdowns. Of the six other experiences, only one, 1974-1977, saw a drawdown worse than the average.”

Given that historical perspective, it certainly seems apparent that investors should NOT be anticipating a Fed rate-cutting cycle. Such should, in theory, coincide with the Fed working to counter a deflationary economic cycle or financial event.

Yet, since the beginning of November, the markets have risen sharply in anticipation of the Fed cutting rates as soon as the first quarter of 2024. More interestingly, the worse the economic data is, the more bullish investors have become looking for that policy reversal. Of course, in reality, weaker economic growth and lower inflation, which would coincide with a rate-cutting cycle, do not support currently optimistic earnings estimates or valuations that remain well deviated above long-term trends.

Of course, that deviation of valuations has been the direct result of more than $43 Trillion in monetary interventions since 2008, which has trained investors to ignore the fundamental factors.

Has Pavlov’s Experiment Trained Investors

Classical conditioning (also known as Pavlovian or respondent conditioning) refers to a learning procedure in which a potent stimulus (e.g., food) is paired with a previously neutral stimulus (e.g., a bell). Pavlov discovered that when the neutral stimulus was introduced, the dogs would begin to salivate in anticipation of the potent stimulus, even though it was not currently present. This learning process results from the psychological “pairing” of the stimuli.

In 2010, then Fed Chairman Ben Bernanke introduced the “neutral stimulus” to the financial markets by adding a “third mandate” to the Fed’s responsibilities – the creation of the “wealth effect.”

“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose, and long-term interest rates fell when investors began to anticipate this additional action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

– Ben Bernanke, Washington Post Op-Ed, November, 2010.

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