These 3 Charts Show Why Rate Cuts Are Bad for Stocks

The Fed Appears Primed to Slash Interest Rates. Contrary to the Market Reaction, That’s Not Good News.

Short memories are an epidemic on Wall Street. That’s the only way to explain why investors were positively giddy on Wednesday after Fed Chair Jerome Powell’s ominous warning to Congress about the “uncertainties” weighing on the U.S. economy. To investors, economic uncertainties are a good thing, because they insinuate that the Fed may cut interest rates later this month. But history shows that rate cuts are bad for stocks.

That shouldn’t be a surprise. In fact, it should be obvious: When the Federal Reserve cuts interest rates, it’s always due to economic sluggishness or “uncertainties.” In the long term, an uncertain economy is bad for the stock market.

The last time the Fed cut the federal funds rate was September 2007, when U.S. home prices fell, the first major leak before the subprime mortgage crisis dam broke, plunging the U.S. into its worst recession since the Great Depression.

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How did Wall Street respond to that rate cut, from 5.25% to 4.75%? Favorably—the S&P 500 ticked up 2.4% in the three weeks that followed the rate cut, closing at new all-time highs above 1,560 on October 10. But we all know what happened next.

Let me refresh your memory with this 18-month chart, starting in October 2007:

Interest rate cuts are bad for stocks in the long run, as we found out from 2007-09.During that time, the Fed slashed short-term interest rates to near zero, where they remained for seven years.

And what has happened to stocks in the three and a half years since the Fed started raising rates again, in December 2015?

This:

If you’re scoring at home, that’s a 46.5% gain. That’s slightly less than the 53% gain in the three and a half years that preceded it, when the Fed held interest rates at zero. But remember that stocks were still digging out of the 2008-09 market crash; they didn’t get back to pre-recession levels until March 2013.

Want more proof that rate cuts are bad for stocks? Let’s go back to the previous time the Fed starting trimming them. It was January 2001, when the unemployment rate was at 6% and U.S. GDP growth was a mere 1%. Over the ensuing two and a half years, the Fed cut interest rates another 12 times, slashing the federal funds rate from 6.5% to 1% during that time.

Here’s how stocks behaved during those two and a half years of rate cuts:

Again, that’s not a good chart. That’s a 27.5% decline, a bona fide bear market.

So, the only two times the Fed has starting reducing interest rates in the 21st century, two things have happened: they kept reducing rates until they were close to zero, and a long bear market ensued.

Are investors hoping the third time will be the charm? Are they clinging to the 1998 rate cuts, when the Fed slashed rates just three times (from 5.5% to 4.75%) and stocks continued to climb higher nonetheless? (Of course the dot-com bubble soon burst, squashing the rally and precipitating the 2001-03 rate cuts and bear market I just mentioned.)

I doubt it. More likely, investors are focused solely on the short term. And when interest rates are cut, stocks do tend to perform just fine…for a month or so. But the real key after that aren’t the rate cuts, but the economy—if things really worsen and the uncertainties crimp earnings, the bears often have their way. But if the rate cut does engineer a so-called soft landing, the market can do quite well.

I’m not saying you should start selling stocks based on what Chairman Powell said to Congress yesterday. But you shouldn’t view the impending rate cuts as a guarantee of higher share prices.

History says otherwise. And so does the chart.

Chris Preston

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Investment analyst and Chief Analyst of Cabot Wealth Daily, Chris Preston brings you all the latest from the investing world. Sign up to get updates and breaking news delivered FREE to your inbox. Get unlimited access to our library of complimentary investing reports.

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