Wall Street has been rife with volatility since the start of the decade. Investors have experienced the COVID-19 crash in 2020, uninhibited exuberance in 2021 that pushed the ageless Dow Jones Industrial Average (^DJI 0.40%), benchmark S&P 500 (^GSPC 1.02%), and innovation-driven Nasdaq Composite (^IXIC 2.02%) to multiple all-time highs, and the 2022 bear market. Thus far, in 2023, it looks like the bulls are in control, once more.
When short-term volatility and uncertainty creep into the picture, investors are often left wondering where stocks will move next.
Image source: Getty Images.
The bad news is there aren't any foolproof indicators that will accurately tell investors which direction stocks will move 100% of the time over long periods. However, there are a multitude of market indicators and metrics that offer uncanny historic correlations to moves in the Dow, S&P 500, and Nasdaq Composite. Investors who follow these indicators and metrics may have an advantage over those who don't.
One such stock market indicator currently offers a pretty big clue as to where stocks may move next.
This surprising indicator suggests the "new" bull market may have legs
Since hitting their bear market lows in 2022, the Dow Jones, S&P 500, and Nasdaq Composite, have all moved higher by more than 20%. By one definition -- a 20%+ rally following a bear market decline -- all three indexes are now in a "new" bull market.
Yet according to Federal Reserve monetary policy, this new bull market may be just stretching its legs.
Since the nation's central bank began its most-aggressive rate-hiking cycle in four decades in March 2022, the thinking has been that corporate earnings would slow and the U.S. economy would teeter into a recession. In other words, a hawkish Fed is often associated with negative connotations for the stock market.
However, this couldn't be further from the truth, as noted by Carson Group Chief Market Strategist Ryan Detrick.
The S&P 500 is now up close to 5% since the Fed started hiking in March '22.
-- Ryan Detrick, CMT (@RyanDetrick) July 26, 2023
It is actually perfectly normal for stocks to gain during periods of rate hikes. Sure, this time was anything but normal with a vicious bear market in the middle.
Still, this is interesting. pic.twitter.com/9cmCYl55N9
As you can see in the recent post Detrick shared on the platform formerly known as Twitter, the stock market often rises in value during extensive Federal Reserve rate-hiking cycles. Over the past 77 years, there have been 12 hiking cycles where the nation's central bank has increased its federal funds target rate at least five times. From start to finish on these 12 cycles (note, this makes the assumption that the July 26 quarter-point increase is the end of the current hiking cycle), the S&P 500 has been higher 75% of the time. Perhaps more important, the average gain for the benchmark index over these 12 cycles is a hearty 10.6%.
Rate-hiking cycles are almost always undertaken with the U.S. economy in full expansion mode. Since it takes anywhere from 12 to 18 months before monetary policy rate decisions really filter their way into the U.S. economy, it's perhaps not too surprising that stocks continue to outperform.
While this unexpected stock market indicator doesn't have a perfect predictive track record, it suggests the "new" bull market will continue chugging along.
Be wary when the Federal Reserve begins its rate-easing cycle
But I'd remiss if I didn't also point out the other side to this story. Whereas rate-hiking cycles have, historically, been an unexpected source of bullishness for the stock market, rate-easing cycles, ironically, haven't.
If the nation's central bank is cutting rates, it's doing so with the purpose of encouraging lending and spurring growth. It typically undertakes a dovish tone when it sees clear-cut evidence of economic weakness or financial instability. In other words, while the prospect of lower lending rates often leaves investors wide-eyed with expectation of stronger corporate earnings growth, the Fed is often commencing rate-cutting cycles into a weakening or already weaker U.S. economy or stock market.
Effective Federal Funds Rate data by YCharts.
Since the start of the century, the Fed has undertaken three notable rate-easing cycles. In all three instances, the S&P 500 fell into a bear market and didn't find its bottom until well after the initial rate reduction (dates listed below):
- Jan. 3, 2001: In a span of less than a year, the nation's central bank took its federal funds target rate from 6.5% to 1.75%. Ultimately, the S&P 500 shed 49% of its value during the dot-com bubble and didn't reach its bottom until 645 calendar days after the initial rate cut on Jan. 3, 2001.
- Sept. 18, 2007: With the financial crisis taking shape, the Fed entered an aggressive rate-easing cycle that took the federal funds target rate from 5.25% to a range of 0% to 0.25%. The S&P 500 eventually lost 57% of its value and hit its nadir 538 calendar days after this initial reduction.
- July 31, 2019: The third rate-easing cycle of this century began in late July 2019 and saw the federal funds rate shift from a starting range of 2% to 2.25% to 0% to 0.25%. The major indexes hit their bear market troughs during the coronavirus crash some 236 calendar days after the first rate cut.
All told, this works out to an average of 473 calendar days before the broad-based S&P 500 found its bottom following an initial rate cut from the Federal Reserve.
Perhaps the only solace for investors is that Fed Chair Jay Powell sees no evidence of rate cuts being on the table anytime soon.
Image source: Getty Images.
Time is an investors' best friend
While the arrow would appear to be pointing up in the short run for the broader market, history has conclusively shown that, when given the proper amount of time, "up" is the natural direction for the Dow Jones, S&P 500, and Nasdaq Composite.
Even though recessions are a normal and inevitable part of the economic cycle, they're relatively short-lived. All 12 recessions after World War II have lasted between two and 18 months. On the other hand, periods of economic expansion have almost always been measured in multiple years. With the U.S. economy spending a disproportionate amount of time expanding, it's not a surprise to see corporate earnings growing over time, or the major stock indexes climbing to new highs.
Additionally, time has a way of putting poor performance on Wall Street firmly in the rearview mirror.
According to sell-side consultancy firm Yardeni Research, there have been 39 instances since the start of 1950 where the S&P 500 has declined by a double-digit percentage. If the 2022 bear market is excluded, all previous 38 corrections, crashes, and bear markets were eventually wiped away by a bull market rally. History has shown time and again that investors simply need to be patient and trust in their thesis over the long run to consistently grow their wealth on Wall Street.
Regardless of what Jay Powell and the Fed do with regard to monetary policy, history all but guarantees that the Dow Jones, S&P 500, and Nasdaq Composite will be notably higher 20 years from now.
