Over multidecade periods, fortunes are built on Wall Street. But over shorter timelines (think months or the span of a few years), the stock market is highly unpredictable.
Since the start of this decade, the iconic Dow Jones Industrial Average (^DJI 0.40%), benchmark S&P 500 (^GSPC 1.02%), and growth-fueled Nasdaq Composite (^IXIC 2.02%), have bounced back and forth between bull and bear markets. With wild swings becoming somewhat the norm for three-plus years, investors are looking for clues as to what may come next for Wall Street.
Although there isn't an economic datapoint or predictive tool that can, with a 100% success rate, accurately forecast short-term directional movements in the Dow Jones, S&P 500, and Nasdaq Composite, there are a handful of metrics and indicators that have strong correlations to directional moves in stocks.
Believe it or not, monetary policy actions by the Federal Reserve may offer a very strong clue as to what's next for stocks.
Image source: Getty Images.
Should investors be wary of this Fed signal?
The nation's central bank is tasked with sustaining economic growth and keeping unemployment rates low. It does this via its monetary policy tools, which influence money supply.
The mechanism investors are likely familiar with is the federal funds rate, which the Fed adjusts higher or lower to ultimately influence interest rates. Raising the federal funds rate depresses the proverbial brake pedal and makes borrowing costlier. This can be used to cool down the pace of inflation when it gets well ahead of the central bank's long-term target of 2%. Typically, raising interest rates is going to slow economic growth.
On the other hand, a rate-easing cycle is designed to spur borrowing. When the Fed is lowering interest rates, it often becomes easier to access cheaper capital, which can fuel hiring, innovation, and acquisitions. Lowering interest rates would be expected to eventually increase the pace of economic growth.
On paper, a dovish Fed -- i.e., one which is lowering interest rates -- would be considered bullish, while a hawkish Fed, which is raising interest rates, would be viewed poorly by investors. However, history suggests investors may have things backwards.
Effective Federal Funds Rate data by YCharts.
While reducing the fed funds target rate does make borrowing cheaper, the Fed doesn't reduce rates without reason. It almost always enters a rate-easing cycle when the U.S. economy weakens and/or something breaks, such as during the dot-com bubble or the financial crisis. Historically, the start of rate cuts is a signal of bad news to come for stocks.
There have been three rate-easing cycles since this century began, and all three cycles saw the benchmark S&P 500 meaningfully decline. These rate-reducing cycles began in January 2001, September 2007, and July 2019. It took the S&P 500 645 calendar days, 538 calendar days, and 236 calendar days, respectively, to find its bottom following these initial rate cuts. Put another way, it's taken an average of 15.5 months following the first Fed rate cut for the stock market to find its bottom since January 2000.
According to the Federal Open Market Committee's September-released "Summary of Economic Projections," which is commonly referred to as the Fed's "dot plot," most Fed Board Governors expect the target level of the federal funds rate to be lower in 2024. In plain English, the consensus is for the Fed to cut rates, beginning sometime next year.
If history rhymes on Wall Street, once again, the Dow, S&P 500, and Nasdaq Composite could be in for a rough go over the coming year.
Image source: Getty Images.
History repeating would be fantastic news for long-term investors
Considering how strong all three major stock indexes have rallied from their 2022 bear market lows, the prospect of potentially revisiting those lows may not sit well with some investors. But depending on your investment horizon, history repeating itself wouldn't be such a bad thing.
Since the start of 1950, the broadest measure of Wall Street's health, the S&P 500, has undergone 39 separate stock market corrections of at least 10%. That's a double-digit downturn, on average, every 1.89 years, or pretty much right in-line with what investors have witnessed since this decade began.
While stock market corrections and bear markets are probably more common than many investors realize, something else that can practically be written in stone is the eventual recouping of these losses for the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite.
Though no predictive tool can tell investors when downturns will precisely begin or end, history does show that every major downturn is eventually (key word) put into the back seat. In other words, every notable downturn in the stock market has represented a buying opportunity for patient investors.
Statistically, it pays to be an optimist, too.
In June, wealth management company Bespoke Investment Group compared the average length of 27 separate bull and bear markets for the S&P 500 dating back to the start of the Great Depression in September 1929. Bespoke found that the average S&P 500 bear market has lasted just 286 calendar days, or about 9.5 months. On the other hand, the typical S&P 500 bull market endures 1,011 calendar days, or closer to two years and nine months. Simply allowing time to work to your advantage can be highly profitable.
Regardless of whether the Fed remains hawkish or turns dovish in 2024 shouldn't matter much to long-term-minded investors.
