Jerome Powell Is Spearheading Rate Cuts: Based on What History Tells Us, Investors Should Buckle Up for a Bumpy Ride

For more than a century, stocks have been the premier wealth creator. While other asset classes, such as real estate, commodities, and bonds, have done their part to grow the nominal wealth of investors, none of these other strategies have come close to matching the annualized return of stocks over long periods.

Recently, we witnessed the benchmark S&P 500 (SNPINDEX: ^GSPC), growth-fueled Nasdaq Composite (NASDAQINDEX: ^IXIC), and ageless Dow Jones Industrial Average (DJINDICES: ^DJI) all climb to record-closing highs. The rise of artificial intelligence (AI) and quantum computing, coupled with the prospect of ongoing rate cuts by the Federal Reserve, clearly have investors excited about the future.

However, stocks rarely move higher in a straight line for any extended time frame. Though excitement surrounding future interest rate cuts is fueling Wall Street's bull market, history tells us that Fed Chair Jerome Powell's easing cycle is setting stocks up for a bumpy and disappointing ride.

Fed Chair Jerome Powell answering questions following a Federal Open Market Committee Meeting. Image source: Official Federal Reserve Photo.

All is not what it appears when it comes to Federal Reserve monetary policy

Fed Chair Jerome Powell and the other governors of the nation's central bank have two tasks that often work opposite of each other: keep the U.S. economy growing, and keep the prevailing rate of inflation from getting out of hand. Steady growth with modest inflation -- 2% is the historical long-term inflation rate target of the Fed -- is the ultimate goal.

The Fed aims to accomplish its task by adjusting the federal funds rate, which is the rate banks lend their reserves on an overnight basis to other financial institutions.

It can also undertake open market operations, such as purchasing or selling long-term Treasury bonds. Bond prices and yields have an inverse relationship, meaning purchasing bonds and increasing their price can drive down long-term yields. Conversely, selling Treasury bonds can boost long-term yields.

On the surface, the Fed's tool kit appears cut-and-dried. If the nation's central bank is raising the federal funds rate, which ultimately lifts borrowing rates for corporate/personal loans and credit cards, and can have an indirect impact on mortgage rates, it should be viewed as a negative for corporate America. It's akin to the Fed pumping the brakes on the U.S. economy.

Conversely, if the central bank is lowering the federal funds rate, logic would dictate that it's trying to encourage corporate borrowing and provide a boost to economic growth.

Effective Federal Funds Rate data by YCharts.

Yet there's another variable mixed into these decisions that hasn't yet been mentioned: reactivity.

The nation's central bank makes its monetary policy decisions based on backward-looking economic data. It's a reactive, not proactive, entity, which means its actions often have the opposite effect of what's implied.

For example, the Fed typically increases its fed funds rate when the U.S. economy is firing on all cylinders. In such a scenario, stocks tend to outperform, even with corporate borrowing costs climbing and bond yields becoming more attractive.

On the other hand, the central bank usually undertakes rate-easing cycles when something is amiss. This might include a weakening job market, evidence of deflation, or other economic indicators that suggest a heightened probability of a recession.

The Fed is currently in a rate-easing cycle, and based on what history tells us, that's terrible news for stocks.

Rate-easing cycles have been a warning for Wall Street in the 21st century

Since this century began, the nation's central bank has undertaken four separate rate-easing cycles, including the present. In each of the previous three cycles, the broad-based S&P 500 endured a meaningful bear market.

The first easing cycle of the 21st century began less than a year after the dot-com bubble took shape, and continued amid the tragic terrorist attack on America in September 2001. On Jan. 3, 2001, the Fed ushered in a 50-basis-point reduction of the federal funds rate to 6%. By Dec. 11, 2001, the nation's central bank had reduced its fed funds rate from 6.5% to 1.75%.

But as you'll note in the chart, the S&P 500 and Nasdaq Composite reversed modest gains in the early days of the Fed's easing cycle to lose 42% and 57% of their respective value by October 2002. The mature stock-driven Dow Jones Industrial Average didn't fare much better, with the index losing a third of its value.

^DJI data by YCharts. Return rate from Jan. 3, 2001-Oct. 9, 2002.

The second dose of dovish monetary policy this century occurred mere weeks before the financial crisis (aka, Great Recession) took shape. On Sept. 18, 2007, the Fed lopped 50 basis points off of its federal funds rate to 4.75%. By Dec. 16, 2008, with America's financial system in dire straits, the Fed had lowered the fed funds rate to a record-low range of 0% to 0.25%.

None of Wall Street's major indexes were spared during the Great Recession, with the iconic Dow and tech-reliant Nasdaq plunging 52% following the first rate cut in September 2007, and the S&P 500 shedding 55% of its value.

^DJI data by YCharts. Return rate from Sept. 18, 2007-March 9, 2009.

The third instance of Fed rate cuts this century began on Aug. 1, 2019, under current Fed Chair Jerome Powell. In what Powell termed a "mid-cycle adjustment," the nation's central bank lowered the fed funds rate by 25 basis points to a range of 2% to 2.25%. But due to the unforeseen COVID-19 pandemic, which manifested mere months later, the Fed again slashed its fed funds rate to 0% to 0.25% by March 16, 2020.

Although stocks initially rallied following the kickoff of the Fed's rate-easing cycle in August 2019, the Nasdaq Composite, S&P 500, and Dow Jones plunged 15%, 24%, and 30%, respectively, from day one of rate cuts to their trough on March 23, 2020.

^DJI data by YCharts. Return rate from Aug. 1, 2019-March 23, 2020.

History is crystal clear: Fed rate cuts correlate with eventual trouble for stocks.

Correlations work both ways

If there's a silver lining among this data, it's that correlations are a two-way street that, historically speaking, strongly favor long-term, optimistic investors.

This isn't to say that stock market corrections, bear markets, and even the occasional elevator-down crash won't occur, because these are perfectly normal, healthy, and inevitable events that manifest during investing cycles. If history were to repeat, the current dovish monetary policy from the Fed will coincide with another sizable dip in equities.

However, history also tells us that market cycles are anything but linear.

For instance, the U.S. economy has navigated its way through a dozen recessions since World War II came to a close 80 years ago. The average downturn resolved in about 10 months, with the longest recession sticking around for just 18 months.

In comparison, the typical economic expansion has lasted for approximately five years, with two periods of growth surpassing the 10-year mark. The U.S. economy spends a disproportionate amount of time expanding, which is favorable to corporate earnings growth.

We see this same nonlinearity expressed on Wall Street.

It's official. A new bull market is confirmed.

The S&P 500 is now up 20% from its 10/12/22 closing low. The prior bear market saw the index fall 25.4% over 282 days.

Read more at https://t.co/H4p1RcpfIn. pic.twitter.com/tnRz1wdonp

-- Bespoke (@bespokeinvest) June 8, 2023

As noted, stocks have been the premier wealth creator among all asset classes over the long run. In June 2023, the researchers at Bespoke Investment Group compared the calendar-day length of every bull and bear market in the S&P 500 dating back to the start of the Great Depression in September 1929 and found quite the variance.

In one corner, the typical S&P 500 bear market persisted for 286 calendar days, or the equivalent of 9.5 months. On the other end of the spectrum, the average S&P 500 bull market stuck around for 1,011 calendar days, or approximately two years and nine months.

Even when stock market correlations appear dire, investors with a long-term mindset have time on their side.

Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.