If you’re bearish (post Fed hikes)…

Since it seems the last Fed hike is quickly approaching, it’s worth taking a look at what happens to equities after a tightening cycle.  The conventional wisdom states that the market should act well after the last Fed hike, like it did after 1994.  However, several different analysis methods forecast a difficult 2006 for the equity markets. 

It’s often a bad idea to bet on conventional wisdom, as Bear Sterns strategies Francois "All-Star" Trahan points out in his November 19th report.  He points out that in the 1950s and 1960s, the market actually went down post a tightening cycle…

Currently, the most common belief among Wall Street pundits is that the equity market will soar ahead as soon as, if not slightly before, the end of the Fed tightening cycle — à la 1994-95. The thinking behind this theory is fairly simple: “Equities typically do well when the Fed is done raising rates.” We would have no issue with that statement if the analysis were limited to the 1980s/90s. Very true, in those two decades, stocks rallied strongly following the last rate hike of a tightening cycle. That said, the reason equities did well in those episodes is explained by the sharp decline in bond yields that typically followed the end of a tightening phase.

The key question we would raise is whether equities can behave this way and rally strongly when the ten-year Treasury yields a mere 4.5%. In our opinion, the answer to that question is no! In that sense, we believe the 1950s/60s, or the last time long-term rates were range-bound at these levels, have more to offer as to what lies ahead for equities here than the 1980s/90s.

The most important element of the equity equation near the end of a tightening cycle is the behavior of market multiples. In the 1980s/90s, a world marked by a secular decline in long-term rates, the forward multiple of the S&P 500 was largely influenced by gyrations in the long end of the yield curve. As such, the catalyst that fueled equities following the last rate hike of the Fed tightening cycle was a decline in bond yields.

Interestingly, things did not always unfold this way. Indeed, in the 1950s/60s, a world marked by low and range-bound long-term rates, the forward multiple of the S&P 500 was far more susceptible to changes in economic prospects than mild variations in long-term interest rates. In other words, multiples then correlated with and looked a lot like leading indicators of the economy. As such, the element that influenced equities in a post-tightening environment was not changes in long-term rates but rather changes in leading indicators of economic activity.

The performance of the equity market in a post-Fed environment will look very different in a 1950/60s world than in the 1980s/90s, which makes sense since the drivers of multiples are very different themselves. The chart above shows that the equity market suffered in the 12-month period preceding the last rate hike of early 1995 and did well thereafter.

This stands in contrast to the 1960s, where equities held their own during the tightening phase only to weaken later, typically when leading indicators were under pressure. A quick glance at market and, in particular, multiple behavior reveals that equities today appear to be behaving a lot more like they did in the 1950s/60s than in the 1980s/90s.

As such, investors should not expect to see the market surge ahead here when it becomes clear the Fed is done, in our view. Rather, the start of the next major move in equities should coincide with a turn in leading indicators, a development that typically occurs a few quarters past the last rate hike.

Similarly, the Bank Credit Analyst points out that a sideways market is much more common than a roaring bull market this far into the upturn.  From the December Bank Credit Analyst…

The stock market upturn began in late 2002, and since then, the trend in real equity prices has closely tracked the average of previous rallies.  The chart is based on the market cycles that followed the previous eight bear markets during the post-WWII period.  If the market was to keep following the historical average, it would imply that prices will make little progress during the next six months or so, before suffering a significant correction in the second half of 2006.  Only then, would a major new rally phase take hold.

Of course, no two cycles are ever the same, and historical averages are made up of diverse experiences.  In the past, the monetary cycle was often in a restrictive phase by the time that an equity bull market had moved into its fourth year, but that is not likely to be the case this time around.  Thus, there will not be any pressure on valuation from rising interest rates, and less risk of a major economic slowdown.  At the same time, corporate sector finances are in much better shape than normal. 

Finally, the four year stock market cycle could start to exert its influence beginning any moment.  The four year cycle has been extremely good at marking market bottom and it’s pointing to a bottom in the Fall of 2006.   

I’ve been bullish based on my belief that the Fed will soon be done with its rate hikes.  However, there’s compelling analysis to show the market doesn’t have to take off to the upside and could in fact stay in its two year trading range before making a more significant bottom next Autumn.