The Fed Will Ease Only After The Market Breaks

US large cap stocks have been supported over recent years by the widespread belief that any weakness will lead to the Fed easing monetary policy, which will prevent any meaningful sustained decline and drive further gains. The market's swift recovery even amid the Covid pandemic is widely seen as evidence that even in dire economic circumstances the Fed has the power to prevent market losses. However, this is the wrong conclusion to draw. Activist monetary policy has only ever supported stocks after a significant market decline has already occurred and sentiment and valuations have been depressed. Once again, easing will only come after substantial market declines, and based on valuations and economic fundamentals, such declines are likely to be rival, if not exceed the losses seen in the 2000-2002 and 2007-2009 bear markets.

Tracking The Fed’s (Non)-Impact On Stocks

Anyone who believes the Fed has the power to prevent bear markets needs only to look at its actions during the 2000-2002 and 2007-2009 bear markets. Major Fed easing cycles failed to prevent 49% and 57% SPX declines during these periods. Even during the bull market since 2009, monetary easing has only been beneficial for stocks after they have already fallen substantially.

The rally following then Fed Chair Ben Bernanke's Jackson Hole speak in August 2010 came after a 17% decline in the SPX when the forward PE ratio bottomed out at 12x. The rally following the announcement of Operation Twist in September 2011 came after a 22% decline in the SPX when the forward PE ratio bottomed out at 11x. The rally that followed the Covid-driven easing came only after a 35% market decline when the forward PE ratio bottomed out at 14x. Taking an average, the past three so-called Fed-driven rallies have come only after a 25% fall and from an average PE ratio of around 12x.

Policymakers Are Backed Into A Corner And Must Break Investor Confidence

The problem now is twofold. Firstly, despite the evidence the narrative that Fed easing supports stocks has led investors to chase up valuations to the point that even if they remain at current extremes, the SPX is likely to post extremely weak returns regardless of monetary policy as argued here. Secondly, the widespread belief that Fed easing will eventually come and support stocks is forcing the Fed to drive up the risk-free rate to prevent further gains. While not explicitly stating this concern, policymakers cannot afford to lower rates while stocks are at current levels due to the link between risk assets and inflation. Any easing risks re-igniting the equity bubble and further driving up inflation via the so-called wealth effect. We are left with a market that now faces immense downside pressure from long-term valuation mean reversion and a Fed that must maintain increasingly restrictive policy even as nominal GDP growth continues to slow.

Current Market And Macro Conditions Are Worse Than At The 2000 And 2007 Market Peaks

The 2000 and 2007 market peaks were characterized by very similar conditions, but I firmly believe they are worse this time around, suggesting there is potential for even more brutal declines. The following table shows key market and macro conditions that tend to correlate with the extent of bear market declines, comparing today with these previous bull market peaks.

While the 2000 market peak arguably had slightly higher valuations and higher real interest rates relative to the growth outlook than we see today, the property market was actually undervalued and debt in the economy was fairly low. At the 2007 peak, while financial sector debt was higher than it is today, equity valuations were much cheaper and real interest rates lower. Meanwhile, the US government debt and net international investment positions were both reasonably low in 2000 and 2007. Taken together, the overall market and macroeconomic picture is far worse than that which prevailed at the previous two major bull market peaks, and the potential for loss even greater.