What Does History Say About The First Rate Hike And Stocks?

Similar Periods From Interest Rate Cycle Perspective

Based on 30-day Fed fund futures prices, the CME Group estimates a 74% probability the Fed will raise rates in December after keeping them steady for years. From a historical perspective, the table below shows the dates when the Federal Reserve began to raise rates following a period of keeping rates steady. If the Fed raises rates on December 16, December 16 would be added to the list below.

Markets Have Numerous Questions To Ponder

In this article, we will walk through all of the periods listed in the table above beginning with 1983. Before we begin that process, it is important to put some context around the market's thought process when the Fed shifts policy from "no change" to "increasing rates". When the Fed is getting ready to shift policy or they have recently shifted policy, the financial markets are continually asking countless questions, including:

• Is the economy strong enough to handle higher interest rates?
• How will the bond market react?
• How will the stock market react?
• Will the Fed raise rates again at the next meeting?
• Will the Fed push the economy into a recession?
• What will the impact be on earnings relative to current valuations?
• Is inflation contained or will it become a problem down the road?
• Will a rate hike push the economy into a deflationary spiral?
• How will inflation impact the economy, markets, and earnings?

If we built decision trees based on the questions above, you can begin to imagine the immense number of permutations and combinations of answers and subsequent paths in the financial markets, which puts some context around the market's indecisive and whipsaw behavior in 2015. As we go through the historical examples below, it is easy to see that it is quite common and rational for markets to be more difficult and indecisive when the Fed is opening up an almost limitless number of "what if" scenarios as they begin to shift interest rate policy.

How Did The Market React To The First Rate Hike?

The Fed kicked off a new rate-hike cycle on May 2, 1983. The first thing that jumps off the chart below is the stock market was indecisive, going up and down, but making no progress between May 1983 and December 1984 (sound familiar?). In 2015, the stock market has gone up and down, but has made no progress between December 2014 and the present day. The S&P 500 closed at 2090 on December 29, 2014. On November 18, 2015, the S&P 500 closed at 2083, which speaks to the market's ongoing indecisive behavior.

Before we move to the "what happened next" chart, take a moment to make a mental note of the "look" of the 50-day and 200-day moving averages in the indecisive 1983-1984 chart above. The 200-day in red goes from bullish, to bearish, to indecisive (flat). The 50-day in blue is all over the place, telling us we have a trendless market.

Hard Period Followed By An Easier Period

It is not uncommon to experience a difficult and frustrating market when the Fed shifts policy, which is the bad news. The good news is hard markets are typically followed by easier markets. Said another way, trendless and indecisive markets are usually followed by markets with much more discernible trends and greater investor conviction.

The pattern held true to form in 1983-1987 (see chart below). Notice how the slope of the 200-day clearly shifts from flat in late 1984 to up/bullish in early 1985. The same can be said for the 50-day moving average; it goes sideways inside the orange box, but then shifts to a series of higher highs and higher lows between early 1985 and mid-1987.

Therefore, under our market model-based approach, if we would have continued to execute faithfully and consistently during the frustrating period (orange box above), we would have eventually been rewarded with positive results. The same can be said for any disciplined and rules-based approach to the markets.

Just Buy And Hold...Right?

You may say who cares?....if you just buy and hold, when the frustrating period ends you will be fine. That sounds good until a bear market comes...more on that later.

1986: Indecisive Market Anticipates Fed Policy Shift

The Federal Reserve began a new rate-hike cycle on December 16, 1986. Prior to the December 1986 hike, the S&P 500 went up and down, but made no progress between March and November 1986, similar to the indecisiveness in 2015. Notice how the 50-day moving average moved into a sideways pattern prior to the rate hike. The 200-day also started to flatten out in late 1986, similar to what we have in November 2015.

1986: Eventually, The Logjam Broke

Discipline and patience were rewarded in 1987 as the stock market rallied 33.7% over the next eight months. The 1987 crash is not shown in the chart below for a reason; stocks rallied significantly for several months following the rate-induced indecisive period.

1988: Volatility & Whipsaws

The Fed began a new rate-hiking cycle on March 29, 1988. The slope of the 200-day moving average in the first half of 1988 tells us the market's profile was quite a bit different than the first six months of 2015. Similar to the previous historical examples, the market showed some erratic behavior in 1988, making no progress between January and June, and again between mid-June and early-December. The slopes of the 50-day and 200-day in December 1988 tell us the bias was bullish heading into 1989. Price action in 1988 also featured higher highs and higher lows.

1989: Gains Were Easier To Capture

The orange box shows a more difficult and indecisive market near the first Fed rate hike. Following the pattern of easier markets tend to follow harder markets, stocks rallied sharply within the context of more easy to discern trends in 1989. Those who executed well inside the orange box were rewarded for their perseverance.

1994: Frustrating, Volatile, And Sideways

Similar to 2015, 1994 was marked by the first rate hike in a number of years. When the Fed raised rates on February 2, 1994, it represented the first rate increase since early 1989. As the market anticipated a "we have not seen this in a long time event", it understandably was indecisive and volatile as it went through the list of common "how will this impact..." questions. If you were running a system based on trends in 1994, it would have been easy to conclude "this does not work". Like 2015, 1994 can be classified as a trendfollower's and systems trader's nightmare.

All Bad Things Come To An End

Markets want to frustrate us. Markets want us to question our process and discipline. Markets can serve as confidence-destroying machines. Nothing is more frustrating than breaking your rules or throwing in the "this does not work" towel just prior to a big "hey, discipline really does pay off!" move. Those who stayed the course with their rules and discipline in 1994 were rewarded big time in 1995 and 1996. 1994 was the harder market; 1995-1996 was the easier market with easier to discern conviction and trends. Harder markets are typically followed by easier markets; something to keep in mind before you throw in the towel in 2015 and 2016.

Easier Markets Can Take The Form Of Bearish Trends

Many who use investing and trading systems can relate to this expression:

"We don't care which way the market goes, up or down; we just want something to trend somewhere on our timeframe."

When markets consolidate, or move sideways in an indecisive manner, the expression below applies:

"The longer a market goes sideways, the bigger the move we can expect, up or down."

The up or down concept applies to the next historical example.

1999: All Good Things Come To An End

Is it possible the Fed hikes rates in December 2015 and stocks rally to new highs only to quickly reverse and enter a multiple-year and principal-destroying bear market? Sure, it is possible. The Fed began a new rate-hiking cycle in the summer of 1999. The S&P 500 made no progress between January 1999 and October 1999. The flat 50-day moving average in the middle of 1999 is indicative of a trendless and frustrating market.

2000: Rate Hike Followed By Devastating Bear Market

The purpose of this post is not to say "stocks go up" after the first rate hike. Given the charts presented here, it is fair to say "stocks typically go up after the first rate hike, but not always." The exception was 1999-2000.

The Fed started a new rate-hike cycle in June 1999. As shown in the chart below, stocks did gain about 8% once the S&P 500 left the orange box, but the easier trend eventually was to the downside. The 200-day rolled over in a bearish manner in late 2000 and the 50-day dropped below the 200-day (both bearish events). The primary trend eventually flipped to down following the more difficult period.

Those who continued to implement their disciplined systems in 2000 were eventually rewarded as a strong downtrend emerged. Discipline can keep you on the right side of the trend, regardless if the trend is up or down.

Pie Charts, Buy & Hold, Bear Markets and Retirement

It is not a question of "if a new bear market is coming", it is just a question of "when will the next bear market begin". If that is the case, it makes sense to water-test your diversified investment portfolio for leaks. We provided a similar "now is a good time to look at this" warning on December 29, 2006 or less than ten months before the financial crisis. The 2006 article, False Diversification May Prove Costly In 2007 showed that what appeared to be a well-diversified portfolio of ETFs or mutual funds lost over 42% in the 2000-2002 bear market. A 2015 analysis, Retirement Investing, 4% Rule, & Drawdowns answers the following important questions:

• How can a bear market impact monthly income in retirement?
• How long can it take to get back to breakeven after a large bear market drawdown?
• Does a diversified mix of ETFs or mutual funds really provide diversification?

2004: Nightmare Number Two

The historical examples presented here tell us 2015's frustrating market is not all that rare when it comes to a new Fed rate-hike cycle. The U.S. central bank began a new cycle by raising rates on June 30, 2004. Like 2015, 2004 featured some big swings up and some big swings down; it also featured a "go nowhere" market with the S&P 500 making no progress between January and November. Those implementing investment or trading systems in 2004 may have rationally begun to say to themselves "this does not work" as they experienced whipsaw after whipsaw. Notice at the end of 2004 the slope of the 200-day was flat, indicating an indecisive market from a long-term trend perspective. The slope of the S&P 500's 200-day moving average is also flat as of November 19, 2015.

Late 2004: Observable Evidence Begins To Improve

The observable evidence began to improve in late 2004 as the slope of the S&P 500's 200-day began to turn back up in a bullish manner, something that can be picked up by a disciplined model. Once the market broke above the orange box of indecisiveness below, the slope of the 50-day turned up sharply and the slope of the 200-day morphed from flat (indecisive) to rising (bullish). The slope of the 200-day moving average between 2005 and early 2007 is indicative of a bullish and more easily discerned trend (stronger investor conviction). Like 2015, 2004 fell into the trendfollower's nightmare category, but it also followed the hard markets are typically followed by easier markets script. Notice easier is not the same as easy; there is no such thing as an easy market.

What Happens If Sideways Action Continues?

Most trading and investment systems have whipsaw provisions. Our market model has various levels of whipsaw rules that are designed to limit trading frequency and whipsaws during periods of consolidation (see April 1 to mid-August 2015). In the present day market, when stocks rallied off the recent low and recaptured the 200-day moving average, the 1998-like scenario was still within the probability mix. Stocks rallied for six straight weeks off the low. The following week the S&P dropped in a manner not seen since 1939 (weekly performance following six weeks of gains). That sharp drop took the 1998 "stocks blow past the 200-day and never look back" scenario off the table. It is possible the market is going to return to a period of consolidation. If so, whipsaw rules will enter the picture under our system to reduce the frequency of allocation adjustments.

Moral Of The Story: Consistent Execution Key To Success

Remember:

• Markets want to frustrate us.
• Markets want us to question our process and discipline.
• Markets can serve as confidence-destroying machines if we break our discipline.

We know two things with 100% certainty. If the S&P 500 rallies for three years and goes on to make much higher highs, the slope of the 200-day will not remain flat as it is today; it will turn up in a bullish manner. Conversely, if the S&P 500 is getting ready to enter a three-year bear market producing significant lower lows, the slope of the 200-day will not remain flat as it is today; the slope will turn down in a bearish manner.

Is the 200-day a foolproof indicator? No, but the same logic applies to numerous indicators and hard data points. Price, the moving averages, and the hard data will not miss the next big move, which is why consistent and diligent implementation of investment and trading systems can keep you aligned with whatever trend comes next (bullish or bearish). The evidence will not miss the next move, but many well-intentioned investors and traders will.

2015: Indecisiveness Is Not All That Rare

The stock market has seen countless "this has never happened in our lifetime" events in 2015. Therefore, we do not want to discount the degree of difficulty over the past year. However, to say "the market is broken and acting irrationally" does not really mesh with the historical first-rate-hike examples above. It is quite common for markets to be confused/difficult/frustrating when the Fed opens countless "what if" doors caused by a major shift in interest rate policy. The other thing that is consistent from a historical perspective is that:

Difficult periods in the stock market are typically followed by easier periods, which underscores the need to continue to stay the course and execute in a consistent manner.