The Fed's Turn Is Nearing -- Here's What It Means for Stocks

Stocks are lower on Thursday, with the Dow Jones Industrial Average (DJINDICES: ^DJI) and the broader S&P 500 (SNPINDEX: ^GSPC) down 0.69% and 0.58%, respectively, at 1 p.m. EDT. The Nasdaq Composite was down 0.71%. Today's July employment report was the penultimate jobs report before the Fed is expected to raise rates in September, so it was highly anticipated by traders and analysts. It turned out to be a bit anticlimactic, as July's numbers were right in line with expectations:     

Source: Labor Department, Bloomberg.

These numbers are enough to keep a September rate rise on the table (in any case, September or December -- what's the difference?). People are understandably a bit concerned about what will happen to markets once the Fed begins to raise rates, as the Fed will be attempting to engineer a clean exit from a monetary experiment that has no precedent. 

The last time the Fed implemented a turn in the interest rate cycle following a prolonged recession was in May 1983, following the 16-month recession of the early 1980s (for reference, the Great Recession of 2007-2009 was 18 months long). Prior to that, you have go back to June 1975, in the wake of the 1973-1975 recession. 

In both cases, the S&P 500 was valued at less than 12 times the average of its inflation-adjusted trailing-10-year earnings (in the earlier case, the multiple was less than 10!). Admittedly, interest rates were already much higher when the Fed began raising them during those cycles, which must have weighed on stock market multiples. 

The S&P 500's so-called "cyclically adjusted" price-to-earnings multiple is currently above 26, which is prompting stock market bears to warn that the market is significantly overvalued and due for a correction (or something more severe).

Of those two earlier episodes, only one -- May 1983 -- proved to be a relatively auspicious opportunity to buy stocks, as the S&P 500 nearly tripled over the following decade. Investors who bought shares in June 1975 saw the S&P 500 roughly double over the next 10 years; unfortunately, that was only enough to tread water in real terms, as the consumer price index also doubled during that period.