For over 100 years, stocks have stood out as the leading driver of wealth creation. While assets like real estate, bonds, and commodities have contributed to growing investors' wealth, none have consistently matched the long-term annual returns delivered by stocks.
Not long ago, the major indexes—the S&P 500 ( ^GSPC 0.53%), the growth-oriented Nasdaq Composite ( ^IXIC 0.52%), and the time-tested Dow Jones Industrial Average ( ^DJI 0.52%)—all reached new record closing levels. Investor enthusiasm has been fueled by advancements in artificial intelligence (AI) and quantum computing, along with the expectation of continued interest rate reductions from the Federal Reserve.
But stock prices rarely rise in a straight trajectory for long. Although optimism about future rate cuts is currently powering the bull market, historical patterns suggest that Fed Chair Jerome Powell’s easing cycle could lead to a volatile and ultimately disappointing period for equities.
Fed Chair Jerome Powell responds to questions after a Federal Open Market Committee Meeting. Image source: Official Federal Reserve Photo.
Federal Reserve monetary policy isn’t always as straightforward as it seems
Jerome Powell and the other central bank governors are tasked with two often conflicting objectives: fostering economic growth and keeping inflation under control. The ideal scenario is steady economic expansion with moderate inflation—2% has long been the Fed’s target for annual inflation.
The Federal Reserve pursues these goals by adjusting the federal funds rate, which is the interest rate at which banks lend reserves to each other overnight.
The Fed can also engage in open market operations, buying or selling long-term Treasury securities. Since bond prices and yields move in opposite directions, purchasing bonds raises their price and lowers long-term yields, while selling bonds has the opposite effect, pushing yields higher.
At first glance, the Fed’s policy tools seem simple. Raising the federal funds rate increases borrowing costs for businesses and consumers, and can indirectly affect mortgage rates, which generally acts as a drag on corporate profits and economic activity. Essentially, it’s like the Fed applying the brakes to the economy.
On the flip side, when the Fed lowers the federal funds rate, it’s typically aiming to stimulate borrowing and spur economic growth.
Effective Federal Funds Rate data provided by YCharts.
However, there’s another important factor at play: the Fed’s reactive approach.
The central bank bases its monetary policy decisions on economic data that reflects past conditions. As a result, the Fed tends to respond to events after they’ve occurred, which can sometimes lead to outcomes contrary to what many expect.
For instance, the Fed usually hikes rates when the economy is performing strongly. In these periods, stocks often do well, even as borrowing costs rise and bonds become more appealing.
In contrast, the Fed typically cuts rates when there are signs of trouble—such as a weakening labor market, deflationary pressures, or other indicators pointing to a higher risk of recession.
The Fed is currently in a phase of lowering rates, and if history is any guide, that spells trouble for the stock market.
Rate cuts have signaled caution for investors in the 21st century
Since 2000, the Federal Reserve has initiated four distinct cycles of rate reductions, including the current one. In each of the previous three, the S&P 500 experienced a significant bear market.
The first rate-cutting cycle of this century began less than a year after the dot-com bubble burst and continued through the aftermath of the September 2001 terrorist attacks. On January 3, 2001, the Fed lowered the federal funds rate by 50 basis points to 6%. By December 11, 2001, the rate had dropped from 6.5% to 1.75%.
But as the accompanying chart shows, the S&P 500 and Nasdaq Composite gave up early gains and ultimately lost 42% and 57% of their value, respectively, by October 2002. The Dow Jones Industrial Average, which is more established, also fell sharply, losing about a third of its value.
^DJI data by YCharts. Return rate from Jan. 3, 2001 to Oct. 9, 2002.
The second round of accommodative monetary policy began just before the onset of the financial crisis, also known as the Great Recession. On September 18, 2007, the Fed cut its rate by 50 basis points to 4.75%. By December 16, 2008, as the financial system faced severe stress, the rate had been slashed to a historic low of 0% to 0.25%.
During the Great Recession, all major indexes suffered: the Dow and Nasdaq both dropped 52% after the initial rate cut in September 2007, and the S&P 500 fell by 55%.
^DJI data by YCharts. Return rate from Sept. 18, 2007 to March 9, 2009.
The third instance of rate reductions began on August 1, 2019, under Jerome Powell’s leadership. Calling it a “mid-cycle adjustment,” the Fed lowered the rate by 25 basis points to a range of 2% to 2.25%. The unexpected arrival of the COVID-19 pandemic just months later prompted the Fed to cut rates again, reaching 0% to 0.25% by March 16, 2020.
Although stocks initially climbed after the August 2019 rate cut, the Nasdaq, S&P 500, and Dow Jones eventually fell by 15%, 24%, and 30%, respectively, from the start of the rate cuts to their lows on March 23, 2020.
^DJI data by YCharts. Return rate from Aug. 1, 2019 to March 23, 2020.
The historical record is clear: periods of Fed rate cuts have consistently been followed by significant challenges for stocks.
Correlations can work in both directions
There is a positive takeaway from this data: correlations are not one-sided, and over the long term, they tend to benefit patient, optimistic investors.
This doesn’t mean that market corrections, bear markets, or even sharp declines won’t happen—they are normal, healthy, and unavoidable parts of investing cycles. If the past is any indication, the Fed’s current accommodative stance may coincide with another significant downturn in stocks.
But history also demonstrates that market cycles are far from predictable or linear.
For example, since the end of World War II, the U.S. economy has weathered a dozen recessions. On average, these downturns lasted about 10 months, with the longest stretching to 18 months.
By comparison, typical periods of economic growth have lasted around five years, with two expansions exceeding a decade. The U.S. economy spends much more time growing than shrinking, which supports ongoing gains in corporate earnings.
This same pattern of nonlinearity is evident in the stock market.
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 . pic.twitter.com/tnRz1wdonp
As highlighted, stocks have outperformed all other asset classes in terms of long-term wealth creation. In June 2023, Bespoke Investment Group analyzed the duration of every bull and bear market in the S&P 500 since the Great Depression began in September 1929, revealing significant differences.
On one hand, the average S&P 500 bear market lasted 286 days, or about 9.5 months. On the other, the typical bull market endured for 1,011 days, which is roughly two years and nine months.
So even when market correlations seem unfavorable, those who invest with a long-term perspective have time working in their favor.
