The consensus view in the investing world right now is that the Federal Reserve has its foot so firmly on the economic gas pedal that stocks canâ€™t fall. But bear markets can coincide with monetary stimulus, so investors should be aware of what might mark the start of one.
There is no question that the Fed is trying hard to help the economy weather the coronavirus crisis. The central bank said in late March that it would provide as much stimulus as needed to achieve that.
It is now buying tens of billions of dollars of Treasury debt monthly to keep the price of those securities high, and interest rates low. That forces investors into riskier bonds that offer better returns, such as corporate and mortgage debt, pushing down the cost of loans and encouraging consumers and businesses to borrow and spend.
The federal-funds rate, at near 0%, has a similar effect. Stocks benefit because investors expect better economic growth, and because returns in fixed-income securities are so low.
As of the close of trading on Thursday, the S&P 500 was up 67% since March 23, its low for the year. A new bull market has likely been born.
But the Fed wouldnâ€™t necessarily have to hit the economic brakes for things to fall apart. â€œBear markets [are] possible without tightening,â€ wrote Ned Davis, founder of Ned David Research, in a Monday note to clients. Monetary tightening is when the Fed causes interest rates to rise, or buys fewer bonds, cutting into economic growth and demand, as well as stock valuations, in order to reduce inflation.
Davis noted the U.S. has seen bear markets at times when the Fed was not tightening, citing 1962, 1987, and 2000. The Fed was lowering interest rates in 2000, for example, but a bear market was under way. In late 2000, the fed-funds rate peaked at 6.5% before falling to less than 1% by the end of 2003. The S&P 500 fell about 44% between September 2000 and March 2003.
None of this means we are in for a bear market. That is unlikely. The Fedâ€™s efforts and the government spending package President Donald Trump signed on Sunday, not to mention reopenings made possible as vaccines become more widely available, will support the economy.
The chances of a surge in inflation and interest rates are slim. Inflation â€œand market-implied inflation expectations remain relatively tepid, still below the Fedâ€™s stated comfort range of 2.0â€”2.5%,â€ wrote Jason Pride, chief investment officer of private wealth at Glenmede, in a research note.
Stock valuations, meanwhile, are reasonably fair.
Davis, for one, says not to â€œfight the Fed,â€ but more important, not to â€œfight the tape.â€ The former means that when the Fed has an easy-money policy in place, investors shouldnâ€™t sell stocks. The latter refers to the idea that a recent uptrend in stocks usually portends strength ahead.
In the years since 1968 when financial conditions were easy, with an accommodative Fed, and the S&P 500 trading above its 12-month moving average, the total annual return on the index averaged 18%. The average annual return was 4.5% when the two signals were mixed, or both negative.
Still, there exists some probability of a bear market. Factors that could send stocks south include the emergence of a vaccine-resistant, Covid-19 strain, or other bad news on the vaccine front, Tom Essaye, founder of Sevens Report Research, wrote in a Monday research note. The market rally could also sputter if fourth-quarter earnings figures, which are set to be released next month, show a slowdown in economic activity.
â€œNone of these events would automatically be bearish game-changers, but they are all possible, and they would catch a complacent market off guard, especially if they occur at the start of the year, once year-end tax implications are no longer in play,â€ Essaye wrote.
If the S&P 500 falls 7.2% from Thursdayâ€™s high of 3,702â€”and Mondayâ€™s close may mark a new highâ€”that could mean selling stocks is the best idea. That drop would bring the index to 3,442.
Davis recommends buying if the index rises 8.4% from Thursdayâ€™s close to 4,021. He says that if a sell signal emerges, commercial paper, or short-term and low-yielding corporate debt, may have better price performance than stocks.
Davis isnâ€™t saying to sell stocks. The point is that no investor should ever take the possibility of serious weakness out of the equation.
â€”Carleton English contributed to this article.
Write to Jacob Sonenshine at email@example.com