History Shows The Stock Market Could Fall When The Fed Cuts Rates

I am getting increasingly concerned about a number of potential downside risks for the stock market. I see a lot of froth in the market, which is usually a sign of a stock market top. When I think of froth in the market today, it includes names like GameStop (GME), certain AI stocks, and Bitcoin. I also see so much complacency and high expectations in terms of the idea that the Federal Reserve is going to pull off a “soft landing” or even “no landing”. In addition to these and other concerns I have, the valuation of the stock market has risen to levels that are not very attractive, especially for value investors. Let’s take a closer look at some of my biggest concerns:

The S&P 500 Index (SPY) is trading for well over 20 times earnings. This level has often been associated with previous market tops. It is worth pointing out that valuation matters and when the stock market is trading at historically rich levels and near record highs, there could be a steeper correction when a correction comes, whether it is due to a recession or another factor. As the chart below shows, the stock market has had a very good run and now looks a bit “toppy” in my view.

Geopolitical Risks

There’s a lot of extremely negative geopolitical issues going on in the world, and yet it seems like most investors are complacent with these concerns. We have seen wars develop in Ukraine and the Middle East. The possibility of China invading Taiwan is another threat we have heard about, as Chinese warships conduct strategic exercises to potentially enable this goal. There is significant strategic analysis which suggests China allegedly wants to be prepared to invade Taiwan by 2027, if deemed necessary. That is just over two years away, which is not far off at all. So far, nuclear bombs have not been used in Ukraine, but I believe that risk might be increasing, especially since President Biden just gave the green light for U.S. weapons to be used to strike inside some parts of Russia. The use of a nuclear weapon today or the invasion of Taiwan seems unthinkable, but the unthinkable does happen at times, Covid is just one recent example.

Consumer Spending Slowdown

The U.S. consumer has been resilient, but that is probably thanks to a record level of stimulus that the government handed out over the years. This cash appears to be drying up as auto loan delinquencies rise and credit card debt reaches record levels. In fact, auto loan delinquencies have just reached decade-long highs. The St. Louis Federal Reserve Bank has recognized there is a broad and continuing rise in credit card delinquencies and this means many consumers are likely tapped out, and more consumers could succumb to this as rates remain high. If we start to see job losses, these auto and credit card delinquencies could surge.

Taxes Are Probably Going Higher

President Biden is proposing a number of tax increases, and some of them could be very significant depending on your tax bracket. This potentially could just be the tip of the iceberg, and more tax increases could be needed and announced after the election. The national debt is now nearing a whopping $35 trillion, and this appears unsustainable, especially with interest rates on the debt being as high as they are now. I believe we are going to have to pay the price for the trillions of dollars that were shoveled out the door during the Covid years and for all the student debt that has been forgiven, and when taxes take a bigger cut on someone’s income, that potentially can lead to spending cutbacks. Tax increases will likely be a headwind for the economy in the years ahead, as the U.S. needs to address the massive debt burden it has created after years of spending.

The Federal Reserve Has A Terrible Track Record

Just over a couple of years ago, Janet Yellen, Jerome Powell and other Fed officials were telling us that inflation was transitory. We were also told that there would be no rate increases through 2022.

But as it became clear to Fed officials that inflation was out of control, interest rates were hiked 7 times in 2022, which is in deep contrast to previous statements. When you consider this, I have major doubts when it comes to credibility at the Federal Reserve, and yet it seems that a very large group of analysts and investors seem to believe that the Fed is going to miraculously pull off a soft landing. I am skeptical of the Fed’s predictive powers, and it seems clear that the Fed is looking in the rearview mirror instead of seeing what is coming up ahead. There was a considerable lag time for the full impact of many inflationary policies to hit the U.S. economy and consumer and the Fed did not appear to see this coming when it predicted that inflation was transitory and that there would be no need for rate hikes in 2022.

Just as there was considerable lag time for the full impact of inflation to hit, I believe there is considerable lag time for the full impact of what has been a historically very aggressive rate hiking cycle. By the time the full impact hits, it will probably be too late for a soft landing scenario, in my opinion.

The Fed waited so long to recognize the coming onslaught of inflation before it hit the U.S. economy and consumer like a ton of bricks, and I believe the same mistakes are being made now in recognizing the multiple signs of economic strains that are developing in everything from commercial real estate to bank balance sheets which have massive bond losses.

The Stock Market Often Plunges After Rate Cuts

The stock market appears to be levitating on the hopes that the next move by the Federal Reserve will be to cut rates. It seems to make sense that the market would rally when rates drop, but the problem is that the market has already pushed higher on the expectations of rate cuts. The even bigger problem with all this is that rate cuts might not be a good thing. The reason rate cuts could be a negative is because The Federal Reserve is often behind the curve and this means that by the time the Fed starts cutting rates, it is already too late, and an economic downturn is starting or well on its way. As Meeder Investment details below, there is a very strong historical precedent for the market to plunge by more than 20% after the first rate cut:

“Many investors believe the stock market will perform well after the Fed starts cutting interest rates. History tells us this is not necessarily true. Since 1970, more than half of the Fed’s first cuts were followed by declines of more than -20% by the S&P 500 Index. Soft landings are easier said than done. Historically during recessions, the Fed underestimates the increase in unemployment by 2.5%.”

Warren Buffett Has Record Levels Of Cash

Warren Buffett appears to be hoarding cash and could have nearly $200 billion amassed by now. By holding so much cash, Warren Buffett appears to be taking advantage of the high rate of interest that cash currently yields, but it could also be a telling sign that he doesn’t see a lot of opportunity to invest. It can also be taken as a sign he is preparing for what could be big buying opportunities in the future, especially in the event of a recession.

Potential Risks Of Reducing Stock Exposure

There is of course the possibility that this time is different, and the Fed will pull off a soft landing. In this case, stocks could keep going higher. Perhaps peace deals will be made in the Middle East and in Ukraine, which would reduce geopolitical risks and give the market a reason to rally. A potential boom in AI or an even bigger bubble (as some would call it) in AI might be enough to counteract other negative issues the market and the economy might be facing. If AI is as revolutionary as some analysts believe, it might be enough to smooth out any potential policy mistakes the Fed might make. I do see lots of interesting opportunities and potential in terms of AI, but even more so when AI converges with hardware, and we see the profound impact that humanoid robots could have on our lives and the economy. All of these reasons are why I am not selling out of everything in my portfolio, just being more cautious and making sure I have high levels of cash, just as Warren Buffett does.

What If I Am Wrong?

I am not cashing out all my chips, I am just being more selective about new stock buys, and I am keeping my core holdings, so I will continue to make money if the market continues to rally. I will just have more cash on hand and more exposure to bonds than I have had in the past few years. The great thing about having more cash around is that it generates even more cash with rates as high as they are now.

In Summary

It’s time to prepare for tougher times ahead. I think all the stimulus money given away in the past few years, plus what was once ridiculously low interest rates prior to the recent rate hiking cycle, has all contributed to record asset prices and signs of froth in everything from real estate, to stocks, to Bitcoin, NFT’s, watches and more. Tax hikes could be coming, and some consumers appear to be tapped out, and we have not even seen job losses or other factors which could quickly snowball into a downward spiral. I think the Federal Reserve has already missed the chance for a soft landing, and that economic data that will be forthcoming in the next 6 months or so will bear this out. Again, I feel like many investors are expecting a new bull market to start as soon as the Fed cuts rates, but as history shows, this is not always the case.

Between all of this and a myriad of geopolitical risks, I am taking a more disciplined approach when I make new investments and I have also made sure my portfolio has significant cash reserves so that I can embrace a market correction and/or recession. I am still bullish long term and plan to continue taking advantage of trading opportunities.

I would sell the major indexes like the S&P 500 Index, but I still like many individual stocks. I am going to keep core positions such as Alphabet (GOOGL), Amazon.com (AMZN) and many others. But again, I think this is a good time to take some risk off the table, especially after the amazing run that the stock market has enjoyed. Finally, I am continuing to focus on increasing my exposure to bonds, as I do expect interest rates to decline significantly in the next couple of years whether or not we see a recession.

No guarantees or representations are made. Hawkinvest is not a registered investment advisor and does not provide specific investment advice. The information is for informational purposes only. You should always consult a financial advisor.