Can Federal Reserve Rate-Hiking Cycles Predict Stock Market Moves? Here's What History Tells Us

Pardon the cliché, but Wall Street's only certainty is uncertainty in the short term. Over the trailing two years, investors have witnessed the ageless Dow Jones Industrial Average (^DJI 0.40%), broad-based S&P 500 (^GSPC 1.02%), and growth-driven Nasdaq Composite (^IXIC 2.02%) rocket to new highs, get buried by a bear market, and now bounce back.

Wild swings on Wall Street, coupled with an uncertain economic environment, often leave investors wondering which direction stocks will move in next. Although there's no such thing as the perfect indicator when it comes to predicting stock market moves, there are data points and metrics that offer historically strong correlations to stock movements.

Interestingly enough, one of those indicators is Federal Reserve monetary policy.

Image source: Getty Images.

The Fed changing its tune isn't an all-clear for Wall Street

The Federal Reserve is our nation's central bank, and it's tasked with overseeing changes to our nation's money supply. These changes are usually geared at spurring economic growth, minimizing unemployment, and keeping the price of goods and services fairly stable over the long run.

The common way the Fed influences these factors is by changing the federal funds target rate, i.e., the target interest rate at which commercial banks lend their reserve balances to other financial institutions on an overnight basis. Though the Fed doesn't directly control interest rates, changes to the federal funds rate do influence the rates consumers and businesses pay on credit lines, variable-rate loans, and even mortgages, to some extent.

Most new and tenured investors are looking for clues from the Federal Open Market Committee (FOMC), the 12-member body responsible for monetary policy decisions, that the current rate-hiking cycle is over. Since growth stocks often borrow money to hire, acquire, and innovate, an endgame to higher interest rates would be, at least on paper, viewed as a positive.

However, the latest FOMC meeting didn't offer those assurances. In fact, the "Summary of Economic Projections," which is more commonly known as the "dot plot," predicts two additional 25 basis-point (0.25%) rate hikes in 2023 with no forecast rate reductions until next year. 

Effective Federal Funds Rate data by YCharts.

The palpable concern for Wall Street is that initial rate cuts don't signal an all-clear for the stock market, at least based on what history can tell us.

Since the beginning of this century, the Dow Jones, S&P 500, and Nasdaq Composite have endured four bear markets, including the 2022 bear market. The three previous bear markets all found their bottoms well after the Fed had begun cutting interest rates.

Following initial rate cuts that began during the dot-com bubble in January 2001, the financial crisis in September 2007, and in late July 2019, it took the stock market 645 calendar days, 538 calendar days, and 236 calendar days, respectively, to reach its nadir. Since 2000, it's taken an average of 473 calendar days (about 15.5 months) for the stock market to reach its bottom once the Fed begins lowering its federal funds target rate after a hiking cycle. This would suggest a true stock market bottom wouldn't occur until well into 2025.

But wait, there's more

However, the performance of the Dow Jones, S&P 500, and Nasdaq Composite following an initial easing after an extended rate-hiking cycle isn't the only correlation bound to raise some eyebrows. The magnitude of the rate-hiking cycle also plays a key role in how stocks perform.

Over the past 68 years, the nation's central bank has undertaken 13 rate-hiking cycles, as you can see in the table below.

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

Although the jury is still out on lucky No. 13, which is currently ongoing, the 12 previous rate-hiking cycles show a fairly consistent correlation with U.S. recessions. With the exception of the 1983 to 1984 rate-hiking cycle and the 1993 to 1995 rate-hiking cycle, every prolonged period of federal funds target-rate increases since November 1954 has subsequently been followed by a recession.

Another way to look at the above data is by examining the gross increase in the federal funds rate. Any instance where the central bank has overseen a greater than 3.1% aggregate increase in the federal funds rate, U.S. gross domestic product has shifted into reverse 100% of the time. For context, the current rate-hiking cycle has seen the fed funds rate climb by 5%.

Though the U.S. economy and stock market aren't tied at the hip, history tells us that stocks tend to meaningfully underperform in the months following the official declaration of a recession by the eight-economist panel of the National Bureau of Economic Research. We've simply never seen such an aggressive rate-hiking cycle not be followed by a recession.

Image source: Getty Images.

The one prediction long-term investors can confidently make

Based solely on what history has shown us over many decades, the Fed's aggressive rate-hiking cycle should lead to economic weakness and a short-term downturn in the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite. This is an educated guess of the next stock market move given the historic variables we have to work with.

However, it's not as concrete of a prediction as long-term investors can make.

Although short-term movements in the market are unpredictable, the confidence of forecasting equity movements goes up dramatically the further you look out. Since the U.S. and global economy tend to grow over time, and corporate earnings often increase in lockstep with U.S. and global gross domestic product, it's only natural that the major stock indexes also climb over long periods.

While it's true that the Dow, S&P 500, and Nasdaq usually perform poorly during recessions, and the major indexes take time to find their footing following an initial federal funds rate cut, it's equally true that every previous stock market correction and bear market (notwithstanding the 2022 bear market) was eventually cleared away by a bull market rally. Time is the one variable that consistently works in favor of patient investors.

^SPX data by YCharts.

A study I reference often from market analytics company Crestmont Research further drives home the power of time as an ally. Crestmont analyzed what an investor would have, hypothetically, generated in annualized total returns, including dividends, if they'd purchased an S&P 500 tracking index and held that position for 20 years. Crestmont updates its dataset annually and has back-tested its calculations to 1900, giving it 104 ending years (1919 to 2022) of total-return data. 

What Crestmont found is that all 104 ending years produced a positive total return. It hasn't mattered whether investors put their money to work at a short-term peak or during a bear market -- they all generated a positive total return as long as they held for at least 20 years. There's no more ringing endorsement for putting your money to work on Wall Street than an indicator that's gone 104 for 104 since 1900.