As I wrote on Friday, I think we’re at an inflection point in the US stock market. It seems to me the market is now beginning to take seriously the idea that the Fed will soon be beginning to raise interest rates from the current near-zero.
In one sense, this is not Wall Street’s first rodeo. There are plenty of times in the past when the Fed has been reversing emergency monetary accommodation applied during a recession. The investment community has already sifted through them ad nauseam.
On the other hand, the extent and duration of the current monetary easing are both without precedent. At the same time, the way the market factors new information into stock prices has changed considerably over the last decade. The goals and risk preferences of the Baby Boom, the most powerful retail influence on stocks, have shifted as well, as that generation has aged.
Boomers are more interested in income than in capital gains. Hedge fund managers and algorithm-fashioners seem to have very short time horizons–almost reacting to information as it hits the news media rather than anticipating it. (I almost cringe to write this last. It reads a lot like the criticisms made by elderly patrician money managers of the past (whom I made fun of at the time) who held stocks for decades at a time and were struggling to adjust to the faster-paced market of my early years on Wall Street. Still, I think what I’m saying is correct.)
Therefore, I think, we can’t just blindly apply generalizations from the past to our present situations.
two types of tightening
It’s important from the outset to distinguish between two types of Fed tightening:
–restoration of the real rate of interest from negative to positive as the economy recovers from recession, and
–raising the real rate of interest substantially above inflation in order to slow down an economy that’s potentially overheating.
Today, we’re dealing with the first kind, not the second.
what the past tells us
During past periods of Fed tightening of the first type, stocks have been volatile but have generally gone sideways to up. Bonds, on the other hand, go down.
This, in itself, has implications for stock market strategy. Stocks that resemble bonds the most tend to do particularly badly; (at least some of) those that resemble bonds the least do the best.