An old saying cautions one to be careful of what one wishes for. Stock investors wishing for the Federal Reserve to pivot may want to rethink their logic and review the charts.

The second largest U.S. bank failure and the deeply discounted emergency sale of Credit Suisse have investors betting the Federal Reserve will pivot. They don’t seem to care that inflation is running hot and sticky, and the Fed remains determined to keep rates “higher for longer” despite the evolving crisis.

Like Pavlov’s dogs, investors buy when they hear the pivot bell ringing. Their conditioning may prove harmful if the past proves prescient.

The Bearish History of Rate Cuts

Since 1970, there have been nine instances in which the Fed significantly cut the Fed Funds rate. The average maximum drawdown from the start of each rate reduction period to the market trough was 27.25%.

The three most recent episodes saw larger-than-average drawdowns. Of the six other experiences, only one, 1974-1977, saw a drawdown worse than the average.  

So why are the most recent drawdowns worse than those before 1990? Before 1990, the Fed was more active. As such, they didn’t allow rates to get too far above or below the economy’s natural rate. Indeed, high inflation during the 1970s and early 1980s forced Fed vigilance. Regardless of the reason, higher interest rates helped keep speculative bubbles in check.

During the last 20 years, the Fed has presided over a low-interest rate environment. The graph below shows that real yields, yields less inflation expectations, have been trending lower for 40 years. From the pandemic until the Fed started raising rates in March 2022, the 10-year real yield was often negative.

Speculation often blossoms when interest rates are predictably low. As we are learning, such speculative behavior emanating from Fed policy in 2020 and 2021 led to conservative bankers and aggressive hedge funds taking outsized risks. While not coming to their side, what was their alternative? Accepting a negative real return is not good for profits.

We take a quick detour to appreciate how the level of interest rates drives speculation.

Wicksell’s Elegant Model

A few years ago, we shared the logic of famed Swedish economist Knut Wicksell. The nineteenth-century economist’s model states two interest rates help assess economic activity. Per Wicksell’s Elegant Model:

First, there is the “natural rate,” which reflects the structural growth rate of the economy (which is also reflective of the growth rate of corporate earnings). The natural rate is the combined growth of the working-age population and productivity growth. Second, Wicksell holds that there is the “market rate” or the cost of money in the economy as determined by supply and demand.

Wicksell viewed the divergences between the natural and market rates as the mechanism by which the economic cycle is determined. If a divergence between the natural and market rates is abnormally sustained, it causes a severe misallocation of capital.

The bottom line:

Per Wicksell, optimal policy should aim at keeping the natural and market rate as closely aligned as possible to prevent misallocation. But when short-term market rates are below the natural rate, intelligent investors respond appropriately. They borrow heavily at the low rate and buy existing assets with somewhat predictable returns and shorter time horizons. Financial assets skyrocket in value while long-term, cash-flow-driven investments with riskier prospects languish.

The second half of 2020 and 2021 provide evidence of Wicksell’s theory. Despite brisk economic activity and rising inflation, the Fed kept interest rates at zero and added more to its balance sheet (QE) than during the Financial Crisis. The speculation resulting from keeping rates well below the natural rate was palpable.

What Percentage Drawdown Should We Expect This Time?

Since the market experienced a decent drawdown during the rate hike cycle starting in March 2022, might a good chunk of the rate drawdown associated with a rate cut have already occurred?

The graph below shows the maximum drawdown from the beginning of rate hiking cycles. The average drawdown during rate hiking cycles is 11.50%. The S&P 500 experienced a nearly 25% drawdown during the current cycle.

There are two other considerations in formulating expectations for what the next Federal Reserve pivot has in store for stocks.

First, the graph below shows the maximum drawdowns during rate-cutting periods and the one-year returns following the final rate cut. From May 2020 to May 2021, the one-year period following the last rate cut, the S&P 500 rose over 50%. Such is three times the 16% average of the prior eight episodes. Therefore, it’s not surprising the maximum drawdown during the current rate hike cycle was larger than average.

Second, valuations help explain why recent drawdowns during Federal Reserve pivots are worse than those before the dot-com bubble crash. The graph below shows the last three rate cuts started when CAPE10 valuations were above the historical average. The prior instances all occurred at below-average valuations.

The current CAPE valuation is not as extended as in late 2021 but is about 50% above average. While the market has already corrected some, the valuation may still return to average or below it, as it did in 2003 and 2009.

It’s tough to draw conclusions about the 2020 drawdown. Unprecedented fiscal and monetary policies played a prominent role in boosting animal spirits and elevating stocks. Given inflation and political discord, we don’t think Fed members or politicians will be likely to gun the fiscal and monetary engines in the event of a more significant market decline.

Summary

The Federal Reserve is outspoken about its desire to get inflation to its 2% target. If they were to pivot by as much and as soon as the market predicts, something has broken. Currently, it would take a severe negative turn to the banking crisis or a rapidly deteriorating economy to justify a pivot, the likes of which markets imply. Mind you, something breaking, be it a crisis or recession, does not bode well for corporate earnings and stock prices.

There is one more point worth considering regarding a Federal Reserve pivot. If the Fed cuts Fed Funds, the yield curve will likely un-invert and return to a normal positive slope. Historically yield curve inversions, as we have, are only recession warnings. The un-inversion of yield curves has traditionally signaled that a recession is imminent. 

The graph below shows two well-followed Treasury yield curves. The steepening of both curves, shown in all four cases and other instances before 1990, accompanied a recession.

Over the past two weeks, the two-year- ten-year UST yield curve has steepened by 60 bps!

The post A Federal Reserve Pivot is not Bullish appeared first on RIA.

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Investors Alley
How to Stop Bumping from Crisis to Crisis

Since the pandemic became an official crisis in early 2020, investors have had to deal with crisis after crisis. There does not seem to be a path toward the next bull market for stocks.

I assume we will have another bull market at some point, but the current crisis-to-crisis investment environment makes strategies that rely on capital gains very unreliable.

But there’s one way to make reliable returns even amid all this craziness. And it’s way less stressful, too.

Let me show you…

Here are some of the events that have shaken investors over the last three years:

• The shutdown of large swaths of the economy due to the pandemic
• Massive payments from the government during the pandemic so people could stay home from work
• A stock market bull market powered by companies—many of which were unprofitable even as their sales soared—benefiting from the stay-at-home phenomenon
• The bull market fizzles at the start of 2022, when more than 1,000 of the pandemic darling stocks lose over 70% of their values, with many falling by more than 90%
• Russia’s invasion of Ukraine, and the subsequent sanctions the U.S. and E.U. put on Russia, including cutting off a large portion of Europe’s source of natural gas
• Soaring crude oil and natural gas prices soared, especially in Europe, where inhabitants saw heating and power bills soar by several hundred percent
• “Transitory” inflation that turned persistent at levels not seen for 40 years, leading the Federal Reserve—a bit late to the game—to embark on a path of aggressive interest rate increases to try to get inflation under control
• Ongoing inflation and rising rates crashed bond prices
• The Russia-Ukraine war stretching into its second year
• Venture capital companies hearing a rumor about their favorite bank and telling their client companies to withdraw their cash from Silicon Valley Bank, triggering a bank run and a massive drop in the bank and finance-related stock prices

I am afraid to guess what will happen next month. These crises (some big, some small) are all the result of fast-moving information and slow-moving (or just dumb) bureaucrats.

The strategy used in my Dividend Hunter service provides a more assured way to generate attractive and growing investment results. Throughout the last three years, my Dividend Hunter subscribers have invested for long-term gains and have seen positive results when tracking income.

The Dividend Hunter recommended portfolio has an average yield of about 9%. I don’t recommend trying to time the market or fretting over share price swings. The goal is to buy and accumulate dividend-paying shares, so our income grows quarter after quarter.

If you earn 9% and reinvest all dividends, the income will theoretically compound by 9% per year. In the real world, the compounding actually does even better. You get organic dividend growth, plus the benefit of buying more shares when prices are down and yields up and buying fewer shares with high prices and lower yields.

This is not a get-rich-quick strategy. It’s a building income at an attractive yield and steady rate strategy. And it works through the ups and downs of the markets and the crises of the day.

You can see dramatic results if you regularly add more money into a Dividend Hunter portfolio. My solo 401k is 100% in Dividend Hunter investments. I make monthly contributions to my retirement plan. I use those contributions and the dividends they earn to buy more dividend-paying shares. I track portfolio income by the quarter, and my investment income grows every quarter, to the tune of 25% to 30% per year! I have a very good idea of my potential retirement income for any year I pick in the future.

It takes a dividend mindset to follow the Dividend Hunter strategy. Once a subscriber who follows the strategy gets through a stock market down cycle and recovery, she sees how well it works. I get a lot of thank-yous for sharing the Dividend Hunter way.

How to Stop Bumping from Crisis to Crisis
Tim Plaehn

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Wood's flagship Ark Innovation ETF has dropped 44% over the last year, but has rebounded 19% so far this year.

Wash, rinse, repeat. That’s what Cathie Wood, chief executive of Ark Investment Management, did Monday, repeating some recent trades in big names.

DON’T MISS: Cathie Wood Plows Millions Into Her Newest Investment

Ark funds bought 37,725 shares of Coinbase Global  (COIN) - Get Free Report, the largest U.S. cryptocurrency exchange, valued at $2.4 million as of Monday’s close.

The company’s shares have tumbled 67% over the past 12 months amid turmoil in the cryptocurrency market. But they have rebounded 76% this year, helped by bitcoin’s recovery. Coinbase is the fourth biggest holding Wood’s flagship Ark Innovation ETF  (ARKK) - Get Free Report.

Ark Fintech Innovation ETF  (ARKF) - Get Free Report snatched 18,555 shares of Block  (SQ) - Get Free Report, valued at $1.2 million as of Monday’s close.

Block stock has plummeted 17% since March 21, as short sellers Hindenburg Research published a blistering criticism of the financial services company. It has lost 53% over the last year.

Block is the sixth biggest holding in Wood’s flagship Ark Innovation ETF, moving up one since Friday.

Wood Buys Teladoc, Sells Exact Sciences

Also Monday, Ark funds snapped up 34,266 shares of Teladoc Health  (TDOC) - Get Free Report, the phone/video healthcare provider, valued at $840,500 as of that day’s close.

The company gained great notoriety early in the covid pandemic, when people couldn’t go to their doctors’ office. But the trend faded over the past year, as people returned to their doctors’ offices.

Teladoc shares dropped 65% during that period. Still, they have firmed 3% so far this year in line with other tech stocks. Teladoc is the ninth largest holding in Ark Innovation.

On the selling side, Ark Innovation dumped 41,985 shares of Exact Sciences  (EXAS) - Get Free Report, valued at $2.8 million as of Monday’s close. The company is a medical diagnostics provider famous for its Cologuard at-home colon cancer test.

Exact Sciences stock has ascended 34% thus far in 2023, buoyed by strong earnings but has eased 2% over the last year. Ark has shed more than 3 million of the company’s shares since the beginning of this year. But Exact Sciences is still the fifth biggest holding in Ark Innovation.

Wood’s Lagging Returns

Meanwhile, Wood’s performance hasn’t exactly lit the investment world on fire over the past year, as her young technology stocks have slumped. Ark Innovation has descended 44% during that period and 77% from its February 2021 peak.

Nonetheless, the fund has bounced back 19% so far this year, as tech stocks have rebounded in general.

Mama Cathie, as Wood is known to her fans, defends her strategy by noting that she has a five-year investment horizon. But the five-year annualized return of $7.2 billion-asset Ark Innovation was only 0.43% through March 27, compared with 10.7% for the S&P 500.

The fund’s performance also doesn’t come close to Wood’s goal for annualized returns of 15% over five-year periods.

She may be losing her popularity. Ark Innovation suffered a net investment outflow of $304 million during the past five days. But it enjoyed a net inflow of $156 million over the last year, according to ETF research firm VettaFi.

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