Fed rate cuts and the two recent recessions

Summary

- The last two recessions were preceded by Fed rate cuts.

- Stock market reactions were somewhat different in the two recessions.

- In the early 2000s recession (March 2001 to November 2001) the stock market was already going down by the time the Fed started cutting rates, and continued going down.

- In the Great Recession (December 2007 to June 2009) the stock market reaction to the Fed cutting rates was more optimistic, with a three-month rally that saw the S&P 500 go up by a little less than 10 percent.

- After that initial rally, the stock market dropped by more than 50 percent (in early 2009), with several “sucker rallies” in between.

- Generally speaking, a Fed rate cut at a period when the signs of an upcoming recession are pilling up should be a source of concern for stock market investors.

The last two recessions were preceded by Fed rate cuts

The graphs below are for the period from January 1999 to June 2019, and were generated using Yahoo Finance and the US Federal Reserve Economic Data (FRED) (, ). The graph at the top shows the weekly variation in the S&P 500 index together with its 50-month simple moving average. The graph at the bottom shows the effective federal funds rate.

As you can see, the last two recessions were preceded by Fed rate cuts. The dashed lines suggest that stock market reactions were somewhat different in the two recessions. In the early 2000s recession (March 2001 to November 2001) the stock market was already going down by the time the Fed started cutting rates, and continued going down.

In the Great Recession (December 2007 to June 2009) the stock market reaction to the Fed cutting rates was more optimistic, with a three-month approximately 10 percent rally in the S&P 500. After that, the stock market dropped more than 50 percent, with several “sucker rallies” () in between. Those rallies are common in recessions, including the early 2000s recession.

We want the debt that we do not need

Since there have been many previous recessions before the last two, some business commentators refer back to several of those other recessions to predict the future, and to frame Fed rate cuts in a positive light. Lower rates stimulate economic activity by making credit more easily and widely available, which could in theory prevent a recession.

The problem is that it is human nature to buy more than we can afford, or need, if we can fund those purchases through debt. Most people will want to buy a more expensive car on credit than they can afford either paying cash or with higher interest rates; the latter increase monthly payments. The same goes for homes.

This is all about perceived status, and extends to corporations. Other things being equal, a CEO of a larger and more dominant company will have a higher status among peer CEOs. As a result, companies tend to take on more debt, if it is easily available at low rates, to fund acquisitions or “buy” market share prior to recessions. Conservative use of funds goes out the window if credit is easily available.

As noted above, many business commentators refer back to recessions other than the last two to predict the future. The problem is that the farther back you go, the more different the socio-economic environments tend to be from today. This is why it is probably a good idea to look at what happened more recently when trying to extrapolate to now and the near future.

A Fed rate cut prior to a recession is not a good sign

Should a Fed rate cut at a period when the signs of an upcoming recession are pilling up be a source of concern for stock market investors? Any way you look at it, the answer is “yes”.

Human nature does not change that easily, and greed will not be checked unless things go really bad. When things go really bad, behavior changes. Individuals and organizations become more conservative regarding their finances.

Very likely a Fed rate cut prior to a recession will sustain or even exacerbate the types of behavior that are at the source of the recession.

Having said that, Fed rate cuts are important for the economic recovery and renewal that are normally seen after recessions.

Has the US been funding economic growth with debt?

Summary

- Since the Great Recession real economic growth seems to be largely funded by debt in the US.

- One could argue that the US has a robust economy, so the government can keep on borrowing for several more years, and then simply print money to pay for some of that debt.

- The problem with this approach is that it would could lead to a devaluation of the US dollar, and thus an increase in inflation in the US.

- The bottom line is that the US must reduce its federal debt.

Federal surplus and GDP growth in the US from 1950 to 2018

The graphs below are for the period going from early 1950 to late 2018, and were generated using the US Federal Reserve Economic Data (FRED). This publicly available web resource combines access to an extensive database of world economic data with very nice graphing features (see: ).

The graph at the top shows the federal surplus rate as a percentage of the real gross domestic product (GDP) in the US for the 1950-2018 period. Values below the line indicate negative surpluses, or deficits. The graph at the bottom shows the real growth in GDP in the US for the 1950-2018 period. It is called “real” growth, because it is corrected for inflation.

The difference between GDP growth and federal surplus

Has the US been funding economic growth via federal deficits? Let us see. The graph below shows the difference between the real growth in GDP and the federal surplus rate. Values below the line are for periods in which the US is essentially funding GDP growth through issuance of debt, primarily in the form of treasuries (bills, notes, and bonds), a debt that tends to accumulate over time.

As you can see, since the Great Recession () we have been seeing quite an interesting and unique pattern in the US. Except for a small period of time around 2015, real economic growth seems to be largely funded by debt. The extent to which this has been happening has not been seen since 1950.

Generally speaking, income from taxation gravitates around 17 percent of GDP. This happens, contrary to popular belief, almost regardless of taxation levels. Therefore, GDP growth should lead to a reduction, not an increase, in the federal deficit – since deficits occur when the government spends more than it takes in as income from taxation. The largest proportion of government expenses come from retirement benefits; which grow as the population becomes older.

The danger of inflation

So, what is the big deal? One could argue that the US has a robust economy, so the government can keep on borrowing for several more years, and then simply print money to pay for some of that debt. After all, the amount of US currency in circulation has been steadily increasing over the years ().

The problem with this approach is that it would could lead to a devaluation of the US dollar, and thus an increase in inflation in the US, because an increase in the supply of anything (including money) tends to lead to its devaluation if demand does not increase at the same pace.

Here is a simple analogy. If you lend money to John Doe (JD) in return for JD dollars, and then JD issues more JD dollars to borrow from someone else, you will probably be concerned and want to exchange your JD dollars for something else. For example, you may want to exchange them for Jane Smith (JS) dollars, assuming that JS owes less debt as a percentage of her income than JD.

Generally speaking, that may be the fate of the US dollar, if the federal debt keeps on growing. The US dollar will lose value, leading to inflation, if other currencies or stores of value (e.g., gold) are given preference over the US dollar.

The bottom line is that the US must reduce its federal debt. How can this be done? Increasing taxation levels is unlikely to be a viable solution, as income from taxation gravitates around 17 percent of GDP; as noted earlier, almost regardless of taxation levels.

One possible solution is to significantly increase skill-based immigration of young workers, thus reducing the number of retirees as a percentage of the overall US population. The US is in an enviable position in this respect, as there are many skilled professionals willing to live and work in the US.

Can the stock market collapse without a recession?

Summary

- A “recession” is usually defined as two consecutive quarters of gross domestic product (GDP) contraction.

- Stock market collapses are generally believed to be associated with economic recessions.

- We show that this is not the case, based on data from Australia.

- Even though Australia has experienced uninterrupted GDP growth from 1992 to 2018, its stock market dropped by around 67 percent from late 2007 to early 2009.

The case of Australia

The picture below shows two charts prepared with data from Tradingeconomics.com (). The top chart shows the growth in gross domestic product (GDP) in Australia from 1992 to 2018. The bottom chart plots the S&P/ASX 200 index during the same period. This index is maintained by Standard & Poor's and is seen as the benchmark for Australian equity performance; much like the S&P 500 in the U.S.A.

Note that the index fell by approximately 67 percent from late 2007 to early 2009. This stock market collapse was more severe than the one experienced in the U.S.A. around the same time.

The period from late 2007 to early 2009 broadly coincides with the period widely known as the Great Recession ().

Yet, there was no economic recession in Australia during that period. What happened was a decrease in the rate of GDP growth; from between 4 and 5 percent, down to between 1 and 2 percent.

If GDP growth slows down, earnings growth is also likely to slow down

When GDP growth decreases but does not turn negative, GDP continues growing – but at a slower pace. The growth in company earnings tends to also decrease during such times, even though earnings may continue growing.

Because of various amplification factors – such as impaired consumer confidence, aggressive competition, and higher interest expenses – earnings growth may decrease much more than GDP growth.

A decrease in GDP growth from 4 to 2 percent may lead to a much wider decrease in average earnings growth for a subset of the market (e.g., from 20 to 2 percent), causing a widespread panic about valuations for the entire market.

PE-based valuation

Let us illustrate this through a plausible scenario. An investment of $10,000 will generate a 100 percent return (i.e., approximately double in size) in 9 years if made in shares of a company whose price-earnings (PE) ratio is 26, and whose yearly earnings growth is 20 percent. If yearly earnings growth drops to 2 percent, which is essentially no real growth at a 2 percent rate of inflation, the same investment will double in size in 9 years only if the PE ratio drops down to 12.

In the scenario above, a PE of 26 would have to go down to 12 for a comparable PE-based valuation of the company to be achieved. That is, at a PE of 26, the company would suddenly look very expensive.

The PE drop from 26 to 12 is of approximately 54 percent. That would typically translate into a big short-term decrease in market capitalization, and a big loss to investors, even with mitigating actions such as share buybacks and dividends.

Next S&P 500 bottom? Maybe 1468

Summary

- The S&P 500 index (SP500) has been recently dropping.

- The Shiller (PE10) has also been dropping.

- We can estimate the bottom of the SP500 based on historical PE10 values.

- This estimated SP500 bottom is 1468.94.

Faster moving averages chase slower ones

The picture below shows two charts prepared with Yahoo Finance (). The top chart shows the SP500 together with its 5-month moving average. The bottom chart also includes the 10-month moving average.

This picture illustrates one import point: faster moving averages usually “chase” slower ones. This is, of course, a figure of speech.

The fastest moving average of all is the index itself; e.g., the 1-month moving average of the index measured on a 1-month basis.

The corresponding 5-month moving average is slower, and the 10-month is even slower.

The slowest moving average of all is the average (or mean) of the index over its entire history.

History tells us that, as the gap between the fastest and slowest moving averages increases, so does the likelihood that they will converge with a “vengeance” – at a wide angle.

The Shiller PE ratio

The Shiller PE ratio (PE10) () is based on average inflation-adjusted earnings from the previous 10 years. As such it removes the “contamination” of inflation and other factors that artificially influence the denominator of the standard PE ratio. This is why we use it here.

In October 2018 the PE10 reached 33.01, the second highest peak in its history. Since then it has been going down, presumably chasing a moving average. If it were to bottom, history suggests that it would go down to around the slowest moving average: its historical average of 16.58 (approximately, in October 2018).

The SP500 bottom

The PE10 going from 33.01 to 16.58 would be a drop of 49.77 percent.

The SP500 was 2924.59 in October 2018. A drop of 49.77 percent would take it to 1468.94.