For the past nine months, the Federal Reserve’s benchmark fed funds rate has been steadily going up.
So have stocks.
It has me thinking about the phrase, “Don’t fight the Fed,” which has been a core theme for many equity market analysts and economists over the past decade-plus. For readers who may not be familiar with the adage, it says that if the Federal Reserve is lowering interest rates and easing monetary policy, stocks should go up. The opposite also applies – if the Fed is raising rates and tightening financial conditions, stocks are likely to endure selling pressure, and should therefore be avoided.1
“Don’t fight the Fed” certainly works in many cases. In the years following the 2008 Global Financial Crisis, the Fed anchored the benchmark interest rate to near zero and also kept downward pressure on long-term interest rates via quantitative easing (QE) programs. This extraordinarily easy monetary policy coincided with a 10+ year bull market that started in 2009 and was one of the biggest and strongest the country has ever seen.
In 2022, with inflation soaring in the U.S. and around the world, the Federal Reserve made a full pivot to hawkishness and aggressively raised the Fed funds rate. They also shifted from QE to QT (quantitative tightening), eventually ending monthly security purchases and winding down their balance sheet. Stocks spent the entire year in a bear market.
It’s easy to see how “Don’t fight the Fed” has become a mantra for many. For one, it makes sense that loosening and tightening financial conditions would help and hurt risk assets, respectively. It is also fair to say the adage has worked reliably well for quite some time, spanning multiple cycles.
But the opening lines of my column speak to something different that’s been happening for the last several months. The Fed has continued raising rates and tightening financial conditions, and Chairman Powell has signaled more hikes ahead with a high probability of ‘higher-for-longer’ interest rates. But stocks are rallying, specifically the big tech/growth companies that were supposed to be the most adversely impacted by higher rates.
My purpose of this column is not to debunk the “Don’t fight the Fed” mantra. As I mentioned earlier, there is a pretty clear logic behind loose and tight financial conditions serving as tailwinds and headwinds for risk assets. But the point to be made is that no stock market adage or rule always works – not “Sell in May and go away,” not the Santa Claus rally, not “Don’t fight the Fed.”
Because of the seeming correlation between Fed actions and stock market returns over the last several years, the Federal Reserve has been cast as the single driving force behind stock market returns. But we know that’s not the case. Earnings and dividend growth are also critical drivers of returns, and I would argue that shifting expectations for earnings growth and actual earnings growth are the most important determinants of the stock market’s direction over time. You can see that clearly in the table below:
Interestingly enough, the 1990s were not known as a period of very easy monetary policy, and multiple expansion was quite strong in that decade. And when the Fed was juicing the stock market with low rates and quantitative easing in the 2010s, it was earnings growth that accounted for a bulk of that decade’s gains. The mantra is a good one, but it doesn’t adequately explain how the stock market works.
Bottom Line for Investors
Investors often seek out tidy explanations for why the stock market rises or falls over any given period. That’s how rules and mantras arise in the first place.
But it’s pretty clear to me that the stock market does not follow any rules, does not keep a calendar, and certainly does not rally or sell off for any single reason. The expected direction of interest rates and monetary policy are of course crucial metrics. They influence credit and liquidity, which feeds into economic activity and growth. That makes the Fed very important, too.
But there is an array of other factors that drive growth and profitability, including but not limited to innovation, global economic activity, trade, geopolitics, regulations, labor market trends, and more. How all of these factors affect earnings, expected earnings, and economic growth are what ultimately determine where the stock market goes.
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