Last week was huge for Wall Street and investors. The iconic Dow Jones Industrial Average (DJINDICES: ^DJI), which welcomed two new components on Friday, the benchmark S&P 500 (SNPINDEX: ^GSPC), and the growth stock-propelled Nasdaq Composite (NASDAQINDEX: ^IXIC), all flew to record-closing highs.
While the results of the highly anticipated U.S. election, which saw former President Donald Trump become president-elect, can be attributed for a good portion of these gains, let's not overlook the role our nation's central bank has played in stoking optimism on Wall Street.
Image source: Getty Images.
Federal Reserve monetary policy takes center stage
The Federal Reserve influences interest rates in the U.S. by adjusting the federal funds rate and, occasionally, conducting open-market operations, such as purchasing or selling long-term Treasury bonds to impact yields (the price and yield of a bond have an inverse relationship). The goal for the nation's central bank is to keep the U.S. economy growing, while also having inflation stay under control.
On the surface, the Fed's ability to influence interest rates via its federal funds rate would appear to have night-and-day positive or negative implications. For instance, reducing interest rates would be viewed positively in the sense that it makes borrowing less costly for businesses. If there's greater incentive to borrow, the expectation would be for an increase in hiring, innovation, and acquisitions.
Conversely, if the nation's central bank is increasing interest rates, the implication is that personal and corporate lending will be reduced and economic growth will slow.
However, it can take a year or two for changes in the federal funds rate to have a measurable impact on the U.S. economy and the prevailing rate of inflation. This means the nation's central bank tends to be more reactive than proactive when making changes to monetary policy.
Rate-easing cycles have, historically, boded poorly for stocks
More importantly, what might seem bullish or bearish for stocks, in terms of monetary policy, tends to have the opposite effect.
For example, the Fed typically leans on rate-hiking cycles when the U.S. economy is firing on all cylinders. It did this in March 2022 to combat rapidly rising inflation, which eventually peaked on a trailing-12-month basis at more than 9%.
On the other hand, the Fed has a tendency to lower its federal funds target rate when things don't seem right with the U.S. economy or shock events arise. While the perception is that lower interest rates are good for businesses, history says rate-easing cycles are a worrisome time for Wall Street.
Effective Federal Funds Rate data by YCharts. Grey areas denote U.S. recessions. Chart doesn't reflect the 25-basis-point reduction to the federal funds rate announced last week.
Since this century began, there have been four rate-easing cycles. This includes the current cycle, which saw the nation's central bank reduce its federal funds target rate by another 25 basis points last week. Following the three previous rate-easing cycles, all three major stock indexes plunged.
- Jan. 3, 2001: Over an 11-month stretch, the Fed reduced its fed funds rate by 475 basis points to 1.75%. But it took 645 calendar days after the first rate cut on Jan. 3, 2001 before the stock market found its bottom.
- Sept. 18, 2007: With the first hints of the financial crisis taking shape, the Fed reduced its fed funds rate from 5% to a low range of 0% to 0.25% over a 15-month period. It took 538 calendar days after this initial rate cut for the market to bottom out.
- July 31, 2019: In a seven-month period, leading up to the start of the COVID-19 pandemic, the Fed reduced its federal funds rate by 200 basis points to a range of 0% to 0.25%. It took 236 calendar days for the market to reach its nadir after the first rate cut.
In the 21st century, it's taken an average of 473 calendar days, or roughly 15.5 months, for the Dow Jones, S&P 500, and Nasdaq Composite to find their bottom when the Fed kicks off a rate-easing cycle.
Image source: Getty Images.
Perspective and patience are powerful tools that shouldn't be ignored
Based solely on what history has told us over the last 24 years, rate-easing cycles portend trouble for Wall Street. But history is also a two-sided coin that shows economic cycles and bear/bull markets are anything but linear.
As much as working Americans and investors might dislike recessions, they're a perfectly normal and inevitable part of the economic cycle. Yet what's worth noting about economic downturns is how quickly they resolve.
Since the end of World War II in September 1945, the U.S. has worked its way through a dozen recessions, of which nine were resolved in less than 12 months. Out of the remaining three, none surpassed 18 months in length.
On the other end of the spectrum, we've witnessed two periods of post-World-War-II growth that endured for at least 10 years, along with numerous multiyear economic expansions. Investors who've wagered on the U.S. economy to grow over time are perfectly positioned for success.
The importance of patience and perspective isn't lost on Wall Street, either.
It's official. A new bull market is confirmed.
-- Bespoke (@bespokeinvest) June 8, 2023
The S&P 500 is now up 20% from its 10/12/22 closing low. The prior bear market saw the index fall 25.4% over 282 days.
Read more at https://t.co/H4p1RcpfIn. pic.twitter.com/tnRz1wdonp
The data set you see above was published on social media platform X by Bespoke Investment Group in June 2023, shortly after the S&P 500 was confirmed to be in a new bull market. Bespoke's researchers calculated the calendar-day length of every bear and bull market in the benchmark S&P 500 since the start of the Great Depression in September 1929.
Bespoke found that the average bear market for Wall Street's broadest-based index has lasted only 286 calendar days, or roughly 9.5 months. By comparison, the typical S&P 500 bull market has stuck around for 1,011 calendar days -- and this figure is even higher now since Bespoke's data set was calculated in June 2023.
To add fuel to the fire, 14 of the S&P 500's 27 bull market markets, including the present, have lasted longer than the lengthiest bear market.
While we've been here before, and rate-easing cycles foreshadow a sizable move lower for stocks, the long-term outlook for equities and the U.S. economy remains decisively optimistic.
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Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
