A 68-Year History of Monetary Policy Changes Suggests a Big Move to Come for Stocks

Over long stretches, Wall Street is one of the greatest wealth creators on the planet. But when examined over much shorter time frames, the performance of the major U.S. stock indexes can be a coin toss.

Last year, the arrow pointed decisively lower for Wall Street. The ageless Dow Jones Industrial Average (^DJI 0.23%), benchmark S&P 500 (^GSPC -0.34%), and innovation-driven Nasdaq Composite (^IXIC -0.33%) all entered a bear market and produced their worst full-year returns since the Great Recession.

Image source: Getty Images.

There's no question that bear markets can be unnerving, especially for new investors who haven't seen a drawdown of this magnitude (excluding the COVID-19 crash of 2020) in more than a decade. It has investors new and tenured asking, "Which direction will stocks head next?"

Though there's no specific tool or indicator that's going to answer that question with 100% certainty, history can often serve as a guide to move the odds into investors' favor. At the moment, 68 years of Federal Reserve monetary policy may be telegraphing a big move to come for equities.

The Fed's hawkish monetary policy is a potential warning for investors

The Federal Reserve was created nearly 110 years ago to oversee our nation's monetary policy. The 12-member Federal Open Market Committee (FOMC) is the decision-making body of the Fed that conducts open market operations. The goal of the FOMC is to keep inflation low and employment high, and it attempts to do this by adjusting the federal funds target rate. Changes in the fed funds rate have an impact on the interest rates people pay on credit cards and most loans.

The Fed's interest rate actions tend to be straightforward. The FOMC will raise interest rates to slow down the U.S. inflation rate or a perceived-to-be overheating economy, or lower interest rates to spur lending and economic growth. Since the beginning of 2022, the nation's central bank has been raising interest rates at the fastest pace in four decades.

Data source: Board of Governors of the Federal Reserve System. Table by author.

As you can see in the table above, there have been 13 well-defined rate-hiking cycles since the start of 1955. Not including the current cycle, 10 of the previous 12 rate-hiking cycles have been followed by a recession. The two exceptions were the modest 3.1% aggregate fed funds rate increase in the mid-1980s and the 3.1% fed funds rate-hike cycle of the mid-1990s.

More importantly, every rate-hiking cycle that totaled at least 400 basis points (4 percentage points) over the past 68 years has subsequently been followed by a recession. Based solely on what's happened since the start of 1955, history would suggest the magnitude of the central bank's rate hikes will lead the U.S. into a recession.

Recessions can be a big deal for stocks depending on your investment time horizon

But it's not just history that serves as a possible warning for Wall Street. Even the Fed is offering a cautious outlook.

In mid-April, the minutes from the FOMC's March meeting contained the following excerpt: 

For some time, the forecast for the U.S. economy prepared by the staff had featured subdued real GDP growth for this year and some softening in the labor market. Given their assessment of the potential economic effects of the recent banking-sector developments, the staff's projection at the time of the March meeting included a mild recession starting later this year, with a recovery over the subsequent two years.

On one hand, Wall Street and the U.S. economy aren't linked at the hip. The stock market tends to be forward-looking, which is why it tends to bottom out well before the U.S. economy hits its trough.

History suggests that the worst of the market declines happen during the Recession.

Since 1929, around 2/3rds of the $SPX peak to trough drawdowns have occurred during, not before, US Recessions. $SPY $QQQ $DJIA $AAPL pic.twitter.com/5l5WXduhwq

-- David Marlin (@Marlin_Capital) April 7, 2023

However, the official declaration of a recession by the eight-economist panel of the National Bureau of Economic Research does tend to sting equities in the very short term. According to data from Bank of America Global Research, which was shared by David Marlin, the CEO of Marlin Capital, in the tweet you see above, the bulk of the S&P 500's drawdown occurs after a recession is declared and not before it.

In other words, if the U.S economy is headed for a recession, 95 years of historical data show that stocks tend to perform very poorly in the short time frame after a recession is officially declared.

If you're a trader or have a very short investment horizon, this isn't great news. But if you're a patient investor with a multiyear horizon and cash at the ready, these typically short-lived drawdowns can be blessings in disguise.

Being optimistic and thinking long term give investors their best chance of success

I'm not going to pretend that bear-market drawdowns aren't somewhat scary. The velocity and unpredictability of down days during recessionary periods can test the resolve of investors to stick to their thesis. But trusting the process is often highly rewarding.

For example, the broad-based S&P 500 has undergone 39 separate double-digit percentage corrections since the beginning of 1950. This works out to one correction, on average, every 1.87 years, which shows how common and inevitable moves lower are for stocks.

Image source: Getty Images.

But there's another side to this dataset. Even though corrections have been inevitable, so have the bounce backs from corrections and bear markets. With the exception of the current downturn, every double-digit decline throughout history was eventually recouped (and some) by a bull market. We'll never know when bear markets will begin or how long they'll last, but history shows quite clearly that index-based losses in the Dow, S&P 500, and Nasdaq will eventually be recouped.

To beat the tire on my favorite datapoint, I turn to more than a century of aggregated return data from market analytics firm Crestmont Research. Crestmont analyzed the 20-year rolling total returns, including dividends paid, of the S&P 500 since the start of the 20th century. Effectively, it examined what an investor would have hypothetically generated in annualized returns if they bought an S&P 500 tracking index and held that investment for 20 years.

Crestmont's dataset shows that the 104 ending years (1919 through 2022) all resulted in a positive total return. What's more, only a handful of the ending years examined produced an annualized total return of 5% or less. That compares to half of the 104 ending years generating an annualized total return of 8.9% to 17.1%. In other words, long-term investors often crushed it no matter when they put their money to work. 

Although recessions have a history of negatively affecting stock prices in the very short term, patient investors have a green light to put their money to work.