- The Federal Reserve is getting set to hike interest rates in the next several weeks.
- Many on Wall Street see stocks surviving the front-end hikes as they have in recent decades.
- But according to Jon Wolfenbarger, that won’t necessarily be the case this time.
A commonly accepted thought on Wall Street is that bull markets thrive until the Federal Reserve raises interest rates several times and takes away the figurative punch bowl.
Stocks have done well even during the first few rate hikes, as the chart below from Lance Roberts at RIA Advisors shows.
“On the front end of a rising interest rate cycle, markets do very well,” Ryan Jacob, the chairman and CIO of Jacob Asset management, said. “On the front of a rising rate environment, you need to have a very strong economy. It’s pretty hard to argue it’s not strong.”
But stocks haven’t always thrived until after the Fed has raised their overnight lending rate in a meaningful way. They’ve also fallen before the Fed hikes rates substantially.
If you look back to the late 1960s and early 1970s — which the above chart doesn’t include — stocks fell before the central bank increased the cost of borrowing significantly, said John Wolfenbarger, a former Allianz Global Investors securities analyst and the founder of BullandBearProfits.com.
They’ve also fallen when short-term interest rates aren’t necessarily rising quickly. Short-term interest rates tend to hew closely to the Federal Funds Rate.
Wolfenbarger explained this in recent commentary, highlighting bear markets that started in 1968 and 1972, and where short-term rates were.
This chart compares those episodes to the difference between long- and short-term bond yields. This so-called yield curve turning negative has been an extremely reliable
indicator over the last 50 years. Wolfenbarger observed that it was “flattish” before the 1960s bear market and still positive before the 1970s event.
For reference, here are the 1968 and 1972 bear markets in the S&P 500.
Now, as Wolfenbarger points out, those bear markets happened because investors had anticipated a recession, given the issues in the macroeconomic picture, regardless of what the Fed was doing. That’s arguably not as much the case today, though high inflation threatens what seems to be an otherwise recovering economy.
But his point is that bear markets don’t necessarily have to come after a cycle of significant rate hikes.
He cited Japan’s Nikkei index as another example. The Bank of Japan has held interest rates at zero for several years now, and the Nikkei has still suffered 28% and 32% pullbacks in that time. Over the last 30 years, Japanese stocks have also fallen in three other instances where rates were not rising in any substantial way, if at all.
What’s more, stocks are in a particularly vulnerable position right now, Wolfenbarger said, with valuations at historic highs —
-to-GDP, also known as the Warren Buffett indicator, is still hovering near all-time highs. Plus, monetary policy is already extremely loose, with the federal funds rate remaining near zero and the central bank still pumping stimulus into markets, meaning there is limited ammunition to fight a downturn.
With valuations high, Wolfenbarger said he expects the S&P 500 to be 50% lower a decade from now. He also said there’s it’s possible to have a drop of at least 50% in 2022, and said it may have already have begun. Stocks are down about 6% to start the year.
“With valuations 40% higher than they were at the tech bubble peak, I think there’s going to be a major bear market, well over 50%,” Wolfenbarger said, using the ratio of total value of nonfinancial stocks to the total revenue of nonfinancial businesses as his valuation measure.
“Investors need to understand there’s major risk in the stock market, and investor psychology could switch to being very bearish just on concern about inflation and Fed hikes,” he added.
The bigger picture
Again, most see stocks continuing on their bullish trend this year. The median S&P 500 price target among Wall Street strategists is around 4,800, more than 6% higher than current levels.
This is in large part because the economy looks to be on solid footing by a number of measures. The US added 476,000 jobs in January, significantly more than economists were expecting. Wage growth remains strong and should continue to fuel what has been record consumer spending. And unemployment, at around 4%, continues to inch down toward pre-pandemic levels of 3.4%.
But there’s a major caveat to all of that: inflation. The Consumer Price Index, a main measure of inflation, is at 40-year highs, hitting 7.5% in January year-over-year. The pace of rising prices has consistently surpassed what experts predicted, and it’s unclear if the phenomenon will subside anytime soon. If it doesn’t, a laundry list of threats to stocks could come into play.
For one, consumers may continue to be spooked into holding onto their cash as a result of high prices, hurting profits. Costs for businesses could continue to surge, also hurting profits. The Fed could be forced to hike rates more aggressively — many on Wall Street are already expecting several rate hikes this year — slowing down growth. Bond investors could send prices sinking and yields soaring much more than they already have, providing more attractive opportunities compared to risky stocks.
Some on Wall Street are more bearish on stocks to begin with. Morgan Stanley’s chief US equity strategist, Mike Wilson, has a 4,400 price target on the S&P 500 this year, and has said he sees stocks falling further in the weeks and months ahead. Bank of America’s Savita Subramanian is also relatively bearish, especially in the long term. Her team’s valuation model shows negative annualized returns for the S&P 500 over the next decade.
But Wolfenbarger’s call for a 50% bear market is an outlier. Of course, calls of that nature almost always are. Not many stock market crashes are foreseen by a majority of investors. And yet they still happen.
It’s an uncertain time in the market, especially when compared to the same time a year ago, and it’s fair to argue investors should approach stocks with a higher degree of caution. In many ways, the current environment is unprecedented compared to anything seen in recent decades. So, too, may be the way investors and stocks behave as the Fed tries to stick the landing.
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