Generally speaking, FED rate cuts are a huge plus for the stock market. Rising liquidity is the other side of the coin of rate cuts, and it is LIQUIDITY, above all else, which drives markets. As liquidity increases, it constitutes the fuel needed to power bull markets. When liquidity contracts, it has the opposite impact. Since it is liquidity which drives all great bull markets, and the absence of same which bursts bubbles and catalyzes bear markets, a normal response to a fundamental change in FED policy should have a profoundly bullish impact on the equity market. The FED, after all, is the primary source of liquidity. It is, in the final analysis, the creator, and the terminator of bull markets.
Our experience has been that when the equity market does NOT respond normally to a fundamental change in the FED's monetary policy, it usually signals that something is very seriously wrong. It is frequently a warning that a serious asset deflation impends, or is even underway. We recall that the failure of the equity market to respond durably to the decisive change in FED policy signalled the onset of a severe deflation in stock prices in the 2000-2002 period. During that bear market, equities declined before, during, and after the mild 2001 recession. The decline was one of the worst of the past century, having been surpassed only by the great bear market of 1929-1932, and the bear market of the late 1930s. It took seventeen consecutive FED rate cuts, reducing the overnight FED FUNDS rate by more than 80%, and a 50% decline in stock prices, to eventually produce a new bull market.
Bearing in mind that there are no certainties when it comes to the stock market, and bearing in mind too that the market loves to play tricks on investors, including the trick of establishing a solid, seemingly reliable record of relationships, which it then upends just when YOU are banking on it, we feel it is PRUDENT to infer that the equity market's abnormal response to the dramatic change in FED policy spells MUCHO TROUBLE AHEAD.
What is the current situation? On September 17, 2007, the FED FUNDS rate stood at 5.25%. In a series of cuts, beginning on September 18th, and including the dramatic inter-meeting 75 basis point (bps) cut, followed a little more than a week later by a large 50 bps cut, the FED has brought the overnight rate down to 3%. This constitutes a 42% REDUCTION in the price of overnight money, and has impacted significantly the short end of the yield curve, as is normal.
As for stock prices, the Dow Jones Industrial Average stood at 13,403 at the close on September 17th. Today, 5 months later and 225 bps lower on FED FUNDS, the Dow stands at 12,348. This constitutes a DECLINE of 7%.
