Historically, stocks don’t bottom until the Fed eases

Investors have often blamed the Federal Reserve for market routs. It turns out that the Fed has also often played a role in market rallies. Going back to 1950, the S&P 500 has sold at least 15% on 17 occasions, according to research by Vickie Chang, global market strategist at Goldman Sachs Group Inc. On 11 of those 17 occasions, the stock market managed to touch the bottom. only around the time the Fed turned to easing monetary policy again.

Getting to this point can be painful. The S&P 500 fell 23% in 2022, marking its worst start to a year since 1932. The index fell 5.8% last week, its biggest drop since the pandemic-fueled selloff in March 2020 .

And the Fed is just getting started. After approving its biggest interest rate hike since 1994 on Wednesday, the central bank signaled that it intended to raise rates several times this year in order to keep inflation in check.

The tightening of monetary policy, combined with inflation at its highest level in four decades, has many investors worried that the economy may collapse. Data on retail sales, consumer confidence, home construction and factory activity have all shown significant weakening in recent weeks. And although corporate earnings are currently strong, analysts expect them to come under pressure in the second half. A total of 417 S&P 500 companies mentioned inflation in their first-quarter earnings calls, with the highest number dating back to 2010, according to FactSet.

Over the coming week, investors will analyze data such as existing home sales, consumer sentiment and new home sales to gauge the economy’s trajectory. US markets are closed on Monday for June 19.

“I don’t think the rate of market decline will continue at this rate, but the idea that we’re nearing the bottom is really hard to imagine,” said David Donabedian, chief investment officer of CIBC Private American Wealth.

Mr Donabedian said he had discouraged clients from trying to ‘buy the dip’ or buy shares at a discount in the hope the market would recover soon. Even after a sharp sell-off, stocks still don’t look cheap, he said. And earnings forecasts still look too optimistic for the future, he added.

The S&P 500 is trading at 15.4 times its next 12 months of expected earnings, according to FactSet, just a hair below its 15-year average of 15.7. Analysts still expect S&P 500 companies to post double-digit percentage earnings growth in the third and fourth quarters, according to FactSet.

Other investors say they are wary of the possibility that the Fed will have to act even more aggressively, should policymakers be surprised by another unexpected inflation reading. The University of Michigan Consumer Sentiment Survey, released earlier this month, showed that households expect inflation to continue at a 3.3% pace five years from now, against 3% in May. This is the first increase since January. Separately, the Labor Department’s consumer price index rose 8.6% in May from the same month a year ago, the fastest rise since 1981.

“Our feeling is that if the next inflation figure is very high again, the Fed could [raise rates] even more strongly,” Charles-Henry Monchau, chief investment officer at Syz Bank, said in emailed comments. This could put additional pressure on risky assets such as stocks, he added.

When the Fed started raising interest rates again this year, it said it hoped for a soft landing, a scenario in which it slows the economy enough to contain inflation, but not to the point of triggering a recession.

Over the past few weeks, many investors and analysts have grown increasingly pessimistic about the Fed’s ability to pull this off. The data has already shown signs of slowing economic activity. With rate hikes further increasing the cost of borrowing for consumers and businesses, it’s hard to see any way the Fed can avoid a downturn, many analysts say.

The Fed’s actions “increase the risk of a recession starting this year or early next year and frankly increase the risk that they can’t keep raising rates for as long,” strategist David Kelly global chief at JP Morgan Asset Management, said Wednesday during a conference call with reporters.

“I wouldn’t be surprised if a year from now we have a meeting where the Fed is considering cutting rates,” he added.

Unsurprisingly, stocks generally don’t do well during recessions. The S&P 500 has fallen a median of 24% in recessions dating back to 1946, according to research by Deutsche Bank.

“If we don’t get a recession, we’re approaching extreme territory,” Deutsche Bank strategist Jim Reid wrote in a note.

The silver lining for investors is that when the Fed begins to move towards easing monetary policy, markets have historically reacted positively and quickly, especially if the main cause of their slide was related to bank policy. central, according to Goldman Sachs analysis.

What no one is sure of is when exactly the Fed will shift gears, and how much additional pressure the economy might come under in the meantime.

“I expect the summer to be very choppy,” said Nancy Tengler, chief investment officer at Laffer Tengler Investments.

Write to Akane Otani at akane.otani@wsj.com