To Cut, Or Not To Cut…FED Is The Question

*“Black holes are where God divided by zero.” – Steven Wright

“Unbeing dead, isn’t being alive.” – E.E. Cummings*

We’re living in interesting times indeed. Wherever we look, a new, better, improved version of every product, service, policy or methodology is available for a spin. Some of these trials end up becoming hugely successful, and some of them prove to be disastrous.

In 1994, three smart guys teamed up and formed a hedge fund, which combined cutting edge technology and trading algorithms to provide superior returns for large or institutional investors. They were Myron Scholes, Nobel Laureate co-originator of the Black-Scholes option trading model, a professor of Finance at Stanford, Robert Merton, an MIT professor with Nobel Memorial Prize for his contributions to Black-Scholes, and John Meriwether, head of fixed income arbitrage group at Salomon Brothers. They called their venture Long Term Capital Management (LTCM). Their strategy, coupled with option trading capabilities and hedging, was supposed to be downside proof. Who could question this, when the option trading Gods were in the house?

The first three year returns of LTCM were an impressive 21%, 43% and 41%, net of fees. The whole world of investments was in awe. These guys were surely on to something. They turned 100 dollars to 243 in just 3 years.

If you think that’s remarkable, check this one out: In two of those three years, 1996 and 1997, Russian stock market went up 5-fold. A grandmother who invested in the Russian stock market on behalf of her grandchildren, doubled LTCM’s returns in less time and with less effort. Those were some pretty good times for investors around the globe…all was good…pretty, pretty, pretty good…even great.

Then in 1998, something unexpected happened: Russian Financial crisis. LTCM lost $4.8 billion in less than four months. A private bail out was arranged by the FED, and it was liquidated in 2000. The Russian economy crashed into pieces, many stocks became worthless, the grandmother whose portfolio had handily beaten LTCM to the upside, had done the same to the downside. The end of this story, was not so pretty…not pretty at all.

A few years after this incident, the US stock market had experienced a domestic tech bubble burst in the Nasdaq. Following that in 2008, we had a financial crisis at global scale, during which time, John Meriwether’s next hedge fund adventure also ended up gravely.

There are those who believe in historical tendencies to rhyme, and those disagree with potentially the most hazardous four words: This time is different.

At a time when large US banks (ex: JP Morgan) announce their Q2 economic growth (GDP) estimates at 1-1.5% range, which is a message echoed by different branches of the FED (ex: Atlanta), the Federal Reserve is under pressure to cut rates and stimulate the economy in order to avoid a recession.

Monetary Theory suggests that it is the government’s role to stimulate the economy with fiscal and monetary easing tactics during slow times, and tighten the belt during times of boom to pay for the debt created during previous periods. If not, excess may form and the system may become prone to shocks.

But today, there is a new theory, called “Modern” Monetary Theory. It argues, that there is no need to worry about excess because there is only one indicator to gauge it, and it’s called the inflation rate. As long as inflation is kept at or below the target rate, more and more stimulus is justified.

Proponents of this theory are in power in the current administration and hence the reason why, after a huge fiscal stimulus in the form of tax cuts, there is now a decent chance for a rate cut by the FED in the next few months. I personally do not agree with this approach, but I don’t get calls from DC to hear my opinions, so it is prudent to study potential outcomes of a rate cut.

Black Hole Sun, Won’t You Come

I am not sure if perpetual stimulus packages create a black hole in the system where laws of physics don’t apply anymore or whether they can wash away recessions, but this much I do know: an undead economy doesn’t mean it’s alive and well. After a 10-year growth period, with no rate cuts since 2007, what does the potential road map of rate cuts look like? How could markets react to it?

Here is a historical perspective of the events most likely to come. There have been 16 rate cuts since WW II and in 12 of those cases stocks were up 6 months later by an average rate of 9.75%. So, in most instances, stocks favor tax cuts. The average of positive years was 15.03% and negative years -6.07%.

But this analysis fails to acknowledge a change in FED policies over the years. Before 1981, the FED had waited until the beginnings of a recession to start cutting rates, and so there are 7 cases when the rate cut came in the midst of a recession, when the stock prices were already discounted and so a road to recovery was already being paved. I would argue, those times don’t apply to our current case as right now we are not in a recession. Excluding those, stocks went up 7 out of 9 cases with an average increase of 7.06%. Even a bit muted, the above statement “…, in most instances, stocks favor tax cuts.”, still holds true.

The most important question it appears, is whether a recession follows the rate cut, because that seems to be the driver of returns that follow. With no recession after rate cuts, the average 6 months return after was 11.4% and -8.1% if a recession followed, a big difference. When I played with numbers, this is the most meaningful difference I have found, which has a similar effect on bond prices as well. If a recession follows, then bond prices continue to go up, and if not, as stocks recover, they lose steam.

One last important piece of information before I wrap this up: recency is important. The two most recent rate cuts were in 2001 and 2007. In both cases, like today, stocks were overvalued, the economy was on a growth mode for several years, and the market was concerned a recession was around the corner. Today’s set of facts, sound eerily familiar. What happened after in 2001 and 2007? Stocks went down respectively -4.3% and -11.9% within 6 months of the rate cut, because the cut wasn’t enough to avoid a recession.

In short, rate cuts are good for stocks, if a recession doesn’t follow. But because we have had a long growth period and see asset price inflation, both of which are commonalities with the last two cases, I would use caution. If stocks will go up, historically one beneficiary group has been dividend grower stocks. If you have high stock allocation, I wouldn’t use this as an opportunity to go full on stocks, but if you’ve been on the sidelines, some dividend payer exposure to take advantage of a rally after the rate cut could be a boost to your 2019 returns. I hear comments from smart folks arguing that all this information is already baked in the cake as the markets are anticipating a rate cut, and a rally has already happened as a result. According to this view, without a cut, markets may be disappointed, and with it, satisfied with the status quo. They do have a point, so…curb your enthusiasm.

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy. The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.