Why Rate Cuts Won't Be an Instant 'Fix'

The Weekend Edition is pulled from the daily Stansberry Digest.

The Fed's tone is shifting...

On Wednesday, for its third straight policy meeting since July, the members of the Federal Reserve decided to keep the central bank's benchmark lending rate right where it is – in a range of 5.25% to 5.5%.

The Fed members also floated the idea of multiple rate cuts in 2024... assuming a future in which economic growth slows and the unemployment rate rises while inflation doesn't.

The signal to the markets? I'm paraphrasing the answer...

The pace of inflation keeps coming down, so there's no need to do anything more. The jobs market is showing cracks, though. So we'll keep the finger on the interest-rate "pause" button to prevent further breakage... which is likely already coming.

It's the kind of stance that the stock market takes as "good news," at least in the short term. The prevailing cost of money isn't going any higher, nor is it likely to in the months ahead. And if anything, rates will go lower before they ever increase again.

Sure enough, on the release of the Fed's latest announcement, the major U.S. stock indexes instantly popped higher from flat intraday levels.

Wall Street institutions' trading algorithms were likely quick to digest the new language in the rate-setting Federal Open Market Committee's statement...

Recent indicators suggest that growth of economic activity has slowed from its strong pace in the third quarter.

Investors also quickly digested the news that Fed officials estimate three 25-basis-point rate cuts next year. That's 50 basis points more than they said just three months ago, the last time they published quarterly economic projections.

The committee's "dot plot" – a spread of its members' policy projections – also showed the prevailing thought that four more cuts, totaling a full percentage point, may happen in 2025. Then, more cuts in 2026 would bring the federal-funds rate to 2.9%... toward a long-term goal of 2.5%.

The central bank also expects gross domestic product to grow less than 2% in each of the next three years.

So, the "bad news" is still good – for now...

Fed Chair Jerome Powell still gave his boilerplate speech about the importance of fighting inflation at the end of his opening remarks in his post-meeting press conference. But the Fed's language in its policy statement and projections, and Powell's commentary taking reporters' questions, marked a "dovish" turn.

As Powell said during the press conference...

We are likely at or near the peak rate for this cycle.

At the same time, continuing to hold off on rate increases means the Fed sees enough risks ahead – like a weakening jobs market or a recession – that now outweigh inflation risks.

The start of rate-cutting cycles in U.S. history typically isn't good for the broad stock market. That's especially true when the market is "expensive," as it is now... because rate cuts signal that things aren't great in the economy.

So, we're inching closer to the point where "bad news" might become "bad news" for the markets rather than good. But based on Mr. Market's knee-jerk reaction, we're not there yet.

The Dow Jones Industrial Average hit a new all-time closing high on Wednesday.

Inflation is continuing to fall, too...

Wednesday's producer price index ("PPI") report for November showed prices paid by businesses were unchanged from October... and 0.9% higher than a year ago. Both comparisons beat Wall Street expectations.

Combined with this week's consumer price index ("CPI") data, the inflation story remains the same... The pace is still easing from its 2022 highs. Monthly inflation numbers for the past several months have been on track for the Fed to meet its 2% goal.

Investors have gotten the message...

They increasingly believe the central bank will be more likely to cut rates in 2024 if the jobs market continues to deteriorate. The latest Fed language only supported this idea.

When it comes to jobs, the Fed members have projected a higher, 4.1% unemployment rate – not only in the year ahead, but for the next two years.

So, for us, it's worth considering a scenario where the Fed is compelled to cut its lending rate – which would ripple on to banks and on through the economy – as we think about the year ahead and how to position a portfolio today.

In short, that scenario might be another reason to be careful in 2024...

What do rate cuts typically mean for stocks?

A common perception is that rate cuts are good for stock prices in general. (Hence, the applause from Mr. Market on the Fed's dovish signaling.)

The details are more complicated. Every major financial-news outlet has published coverage of "stocks rising on the hope of Fed rate cuts." But, as I wrote in the Digest recently, here's our caveat...

That is true and timeless advice over the long run. In the shorter run, though, if the Fed sees a need to cut rates, that means the economy, businesses, and everyday people are hurting financially – whether it's called an "official" recession or not.

This is crucial to understand.

Here's a relevant example, shared by QI Research CEO and Chief Strategist – and former Fed employee – Danielle DiMartino Booth, who presented at our annual Stansberry Conference in October...

The Fed won't cut rates when everything is going well for the economy...

It will cut rates, or start sending messages about possibly cutting rates, when things are going wrong. At that point, sell-offs in the broad stock market may have already started.

Stock prices, generally, are likely to fall as the economic trouble builds and growth expectations fall – for whatever reasons – ahead of Fed rate cuts. Plus, history shows the losses may continue for a while even after the cutting starts.

In the past 50 years, after the Fed has started a rate-cutting cycle, the S&P 500 has dropped by an average of 20% after the bank's first cut before hitting a low, according to data from Bloomberg and global institutional brokerage and advisory firm Strategas Research.

Let's take a closer look at the history of market moves before and after the Fed starts cutting rates...

Some sell-offs before the first rate cut have been relatively short... like in March 2020, when it seemed like much of a business cycle was condensed into one month. Similarly, a 100-basis-point rate cut in the weeks after the crash in October 1987 stabilized the markets.

But other rate cuts started amid (or at the start of) longer and deeper drawdowns...

In the high-inflation 1970s, the Fed started cutting rates in mid-1974. Stocks eventually started to turn around into 1975... but not before the S&P 500 had dropped 50% from a previous high in 1972 – including 28% after the first rate cut.

Other rate-cutting-related drawdowns – such as in 2001 to 2002 after the dot-com bubble burst... in 2007 to 2009 during the financial crisis... in 1981 to 1982... and in 1989 to 1990 – lasted much longer, averaging 17 months, and were typically deeper.

The better news? Nearly half of the S&P 500's nine declines after a first rate cut were in the single digits. (And they were followed by strong, double-digit six-month returns.)

But the other five sell-offs were more than 20%... as much as 55% and 42% after the dot-com bubble and in the financial crisis, respectively. And stocks were still down six months after the rate cut.

Again, the Fed signaled this week that it's planning on cutting rates in 2024. Stocks can go higher in the short term because of this.

But the main point is, don't be caught off guard by a sell-off before or after the Fed may actually cut rates.

Now, this doesn't mean that all stocks will behave the same way. Certain businesses – like banks and energy companies – tend to do better early in rate-cut periods, for instance. It will be a challenging environment for many stocks... but also a potential buying opportunity for others.

Joel Litman has a proven system for picking winning stocks – and avoiding losers...

During his brand-new video presentation, Joel – founder of our corporate affiliate Altimetry – explained how he uses "forensic accounting" to discover the true earning power of a business. His analysis goes far beyond the conventional metrics that Wall Street has been stuck with for decades.

I know things like "non-GAAP" accounting might not sound sexy...

But his unique strategy is part of the way to find "perfect stocks" to get ready for what he thinks will be a rocky period ahead. As Joel – who, remember, consults with Wall Street clients, the FBI, and the Pentagon – says in the presentation...

At the end of the day, you don't have to understand a lick of accounting to benefit from what I do.

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Good investing,

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