“Sometimes nothin’ can be a real cool hand.” — Lucas “Luke” Jackson, Cool Hand Luke
Very Good News?
Following the federal open market committee (FOMC) meeting on December 12 and 13, 2023, the Federal Reserve announced it would be holding the federal funds rate within a range of 5.25 to 5.5%. The Fed, by way of its dot plot, also signaled there would be three 25-basis point rate cuts in 2024.
The Fed believes it has conquered the rampant consumer price inflation of its making. Fed Chair Jerome Powell even took the opportunity at a news conference to toot his own horn:
Inflation has eased from its highs, and this has come without a significant increase in unemployment. That’s very good news.
Wall Street celebrated the prospect of future rate cuts by boosting the S&P 500 by 3.6% over the following week.
Interest rate cuts are commonly recognized as being bullish for stocks and stimulative for the economy. The rationale is that the burst of cheaper credit produces a borrowing and spending binge that drives stock market speculation and gross domestic product (GDP) growth.
Here at the Economic Prism, we have some reservations with this thinking. Certainly, low interest rates drive speculation and malinvestment. And asset prices bubble up in strange and unexpected places.
Those who discern where and get in early to the next asset bubbles can do well. However, for general stock market participants — buyers of S&P 500 index funds — things often get worse before they get better, following the commencement of Fed rate cuts.
By this, we expect there will be a great stock market purge in 2024 and 2025 that will take the major indexes to unimaginable lows. We also expect this will coincide with the slashing and burning of interest rates. Here’s why…
The last time a Fed rate hiking cycle peaked out this high was at a federal funds rate of 5.25%. This was attained on June 29, 2006. If you recall, the Fed then paused and held rates at 5.25% for roughly 15 months. Then on September 18, 2007, the Fed cut rates 50 basis points.
A lot happened beneath the surface over these 15 months while the federal funds rate was held at 5.25%. Massive stressors were formed, as this rate was relatively higher than the preceding years. In June 2003, for example, the federal funds rate touched 1% and remained there until June of 2004.
When credit is cheap, opportunities to borrow and spend money are much more manageable. When interest rates are ultra-low, consumers, businesses and governments have the cash flow to cover purchases that would otherwise be extravagant. Bad decisions are subsidized.
But when the federal funds rate is 5.25%, and credit markets are tighter, the cash flow comes up short. Debts go unpaid and slip into arrears. Defaults occur.
The consequences of relatively higher interest rates are not always immediate. The latent effects of cheap credit producing bad debt take time to filter their way through the economy.
Sectors that largely rely on financing to move products — such as real estate and automobiles — are generally hit first. While demand for potted meat, which even with today’s inflation can still be bought with pocket change, remains even.
When the Fed brought the federal funds rate to 5.25% in June 2006 and then signaled a pause, there was a sense of relief. Economists thought the worst of it had come and gone. They believed the stress of higher interest rates had already been realized.
In reality, the experts had been bamboozled by their own bosh. And, as the magnitude of bad debt became fully apparent, the major stock market indexes crashed in tandem.
Between September 2007 and December 2008, Fed Chair Bernanke slashed the federal funds rate from 5.25% to a range of 0% to 0.25%. Perhaps he thought this would buoy the economy and float stocks higher.
In late November 2008, Bernanke crossed the Rubicon with the commencement of quantitative easing (QE). In doing so, he corrupted financial markets and the economy without end … and sowed the seeds of today’s financial and economic chaos.
Over this time, as the federal funds rate was being slashed and QE began flooding the financial markets with liquidity, something unexpected happened. The stock market didn’t go up. Instead, it went down.
The S&P 500, for example, peaked out at about 1,586 in October 2007 — one month after the onset of Fed rate cuts. It then slowly slid down to about 1,200 in August 2008. Over this time, investors thought they were buying the dip. That the Fed had engineered a soft landing. They were dead wrong.
By September 2008, the S&P 500 was freefalling like common ravens descending upon fresh roadkill. Taking it down to a bottom of 666 on March 6, 2009. This amounted to a top to bottom decline of 58%. It was brutal. Yet, for those holding cash it offered the buying opportunity of a lifetime.
As we’ve just documented, the Fed stopped hiking rates in June 2006. The S&P 500 continued to inflate until October 2007. The Fed then began cutting rates in September 2007. The stock market didn’t bottom out until March 2009 — 18 months after rate cuts were first initiated.
What’s the point?
How to Outperform the Stock Market in 2024
The stresses that have built in financial markets and the economy as we enter 2024 are certainly different than those that existed in 2008. The world has dramatically changed over these 15 years. But if you listen with a trained ear, there are similar rhymes.
Massive amounts of bad debt are out there lying in wait. A rapid succession of Fed rate cuts will not be enough to engineer a bailout.
The commercial real estate market, for example, is burnt to a crisp. Similarly, pension funds, having stretched for yield, are holding a bag of assets that are backed by eroding collateral. At the same time, the S&P 500 is still well overvalued relative to its historical mean.
Moreover, the prospect of Fed rate cuts in 2024 doesn’t mean the stock market will immediately buoy higher on a rising tide of cheaper and cheaper credit. First it will have to drown in a sea of bad debt.
Assuming the Fed starts cutting rates in March of 2024, the S&P 500 may not bottom out until September of 2025. Hence, if you want to outperform the stock market in 2024, as measured by the S&P 500, please consider the following recitals:
Whereas history doesn’t repeat. Whereas history often rhymes. Whereas it is expected the Fed will begin slashing interest rates in 2024. Whereas the commencement of Fed rate cuts has coincided with the commencement of bear markets. Whereas a decline in equity prices is commensurate with a relative increase in the number of shares that can be purchased in dollars. Whereas to make money in the stock market one should buy low and sell high.
Now, therefore, in consideration of the facts recited above, and pursuant to the laws of financial markets, and despite Fed intervention, to outperform the stock market in 2024 one should simply do one thing and one thing only: hold cash.
This may be uncool. Holding cash may be considered a portfolio of nothing. Your broker certainly wouldn’t recommend it.
Nonetheless, cash is a position. In fact, it’s a position that sometimes outperforms the stock market. Most recently cash outperformed the stock market in 2022 and in 2018. We believe cash will outperform the stock market again in 2024.
Remember, holding cash provides you with a valuable option. Specifically, it represents the stocks you’ll be able to scoop up at an extreme discount at the bottom of the bear market — where you can be greedy when others are fearful.
Incidentally, Berkshire Hathaway, the business run by Warren Buffett, one of the best capital allocators of the last 70 years, closed out the third quarter of 2023 holding a record $157.2 billion pile of cash.
He’s likely saving up for the next “blood in the streets” buying opportunity. Perhaps you should too.
Happy New Year!
[Editor’s note: Today, more than ever, unconventional investing ideas are needed. Discover how to protect your wealth and financial privacy, using the Financial First Aid Kit.]