The Market Is Behaving Much Like It Did in the Past
The prevailing wisdom these days is that markets are behaving in inexplicable ways.
I have a different view. If the market means U.S. equities, the behavior since the Federal Reserve began this tightening cycle has been very consistent with the behavior of past cycles. It's not sure all that complicated -- it’s about consistent economic growth -- and I am pretty sure fighting it is a losing bet.
If we look at the post-1984 tightening cycles, we see that U.S. equity prices since December 2015 are following an incredibly average path:
Of course, the average hides some different dynamics. For instance, by this time in the 1999 hike cycle the Fed had already set the groundwork to tip the economy into recession. I find it particularly useful to compare the current cycle with those of 1986 and 1994:
Notice the clearly anomalous behavior of the stock market that preceded the October 1987 crash. I think this should caution against expecting a similar kind of crash in the current environment. The dynamics clearly differ between then and now. Hence I tend to think the odds of a market crash such as that of 1987 are indeed rather low.
The 1994 hiking cycle provides a lesson in what would have been should the Federal Reserve stop hiking prior to tipping the economy into recession. This is almost a textbook example of the often-prophesied but rarely observed soft landing. The economy continued to grow uninterrupted and carried stock prices with it.
The general rule is that if the economy continues to grow, then it is more likely than not that stock prices rise, even if the Fed tightens monetary policy. Many analysts, however, continue to resist this historical lesson, largely on the basis of traditional valuation metrics. These metrics, such as PE ratios, have been long elevated, leading to the difficulty explaining market behavior that my Bloomberg View colleague Barry Ritholtz has observed.
But if not market valuations what should be the focus on investors? My view is that they should be watching for signs that, at a minimum, earnings growth will falter or, probably more importantly, that the economy is set to tip into recession. I tend to think it is more likely that the economy takes the equity market down with it than the opposite.
For example, the market stumble that began in 2015 was based in a very real deterioration in the earnings outlook. The oil prices collapse pressured energy producers, and the concurrent rise in the dollar weighed on the overseas earnings of multinational firms. In addition, a weakness spread through the manufacturing sector and with it the threat (albeit a minimal one) of recession. A market correction was a reasonable result.
The challenge to this approach is maintaining a nonbiased perspective. Analysts who believe a crash is imminent based on market valuations may find themselves finding a recession indicator in every other economic report. In the process, they miss the bigger picture: There is no end in sight yet for this expansion.
The economy has simply proved to be much more resilient than many expected, shaking off a series of post-crisis shocks that included the European financial crisis and the great oil price crash. Consequently, the feared hit to stock prices never materialized. Moreover, fears that markets would collapse if the Fed stop monetary easing or raised interest rates were overblown. Also overstated are similar fears surrounding the impending reduction of the Fed’s balance sheet. My expectation is that it will prove to be little more than a ripple through financial markets.
To be sure, it is impossible to know that the future holds. The chaotic environment in Washington, for example, could erupt into a crisis than threatens the economy. A more likely scenario is that the time will come -- as it always has -- when the Fed tightens policy too much and reverses itself too slowly. That is the most likely event that brings down the economy and equity markets. We just aren’t near that point yet.
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