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Equities have historically not bottomed out before the Fed eases




Another week of whipsaw stock trading has made many investors wonder how much longer the markets will fall.

Investors have often blamed the Federal Reserve for market slippage. It turns out that the Fed has often had a hand in market twists as well. Dating back to 1950, the S&P 500 has sold at least 15% on 17 occasions, according to research by Vickie Chang, a global market strategist at Goldman Sachs Group Inc. On 11 of those 17 occasions, the stock market managed to bottom out. just around the time the Fed shifted towards loosening monetary policy again.

Getting to that point can be painful. The S&P 500 has fallen 23% in 2022, marking the worst start to a year since 1932. The index fell 5.8% last week, the biggest decline since pandemic-driven sales in March 2020.

And the Fed has only just begun. After approving its largest interest rate hike since 1[ads1]994 on Wednesday, the central bank signaled that it intends to raise interest rates several times this year so that it can curb inflation.

Tightening of monetary policy, combined with inflation, which is four decades high, has led many investors to fear that the economy could enter a recession. Data on retail, consumer sentiment, housing construction and factory activity have all shown significant weakening in recent weeks. And while corporate earnings are strong now, analysts expect them to come under pressure in the second half. A total of 417 S&P 500 companies mentioned inflation on the income requirements for the first quarter, the highest figure going back to 2010, according to FactSet.

In the coming week, investors will analyze data including sales of existing homes, consumer sentiment and sales of new homes to measure the course of the economy. US markets are closed Monday, according to Juneteenth.

“I do not think the downturn in the market will continue at this pace, but the idea that we are approaching the bottom – it’s really hard to come up with,” said David Donabedian, Chief Investment Officer at CIBC Private Wealth USA.

Fed Chairman Jerome Powell on a NYSE screen on Wednesday, when the central bank signaled that it intends to raise interest rates several times this year.


Photo:

BRENDAN MCDERMID / REUTERS

Mr. Donabedian said he has discouraged customers from trying to “buy dip” or buy shares at a discount with the expectation that the market will soon turn around. Even after a punitive sale, the shares still do not look cheap, he said. And the revenue forecasts still look too optimistic for the future, he added.

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

Other investors say they are wary of the possibility that the Fed may have to act even more aggressively should decision-makers be surprised by another unexpectedly high inflation. The University of Michigan’s consumer sentiment survey, released earlier this month, showed that households expect inflation to run at a rate of 3.3% in five years, up from 3% in May. It was the first increase since January. Separately, the Ministry of Labor’s consumer price index rose 8.6% in May from the same month a year ago, the fastest increase since 1981.

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“Our feeling is that if the next inflation rate is very high again, the Fed can do it [raise rates] even sharper, “said Charles-Henry Monchau, chief investment officer at Syz Bank, in an e-mail comment.” This could put further pressure on risky assets such as equities, “he added.

When the Fed began raising interest rates again this year, it said it hoped to make a soft landing, a scenario in which it slows down the economy enough to curb inflation, but not so much that it triggers a recession.

In recent weeks, many investors and analysts have become increasingly pessimistic that the Fed will succeed. Data have already shown signs of cooling economic activity. As interest rate increases increase borrowing costs for consumers and businesses further, it is difficult to envisage a way for the Fed to avoid a downturn, say many analysts.

The Fed’s move “increases the risk of a recession starting this year or early next year and honestly increases the risk that they will not be able to continue raising interest rates for that long,” David Kelly, global chief strategist at JP Morgan Asset Management, said on a conference call with journalists on Wednesday.

“I would not be surprised if within a year we have a meeting where the Fed is considering cutting interest rates,” he added.

Not surprisingly, stocks usually do not do well during recessions. The S&P 500 has fallen a median of 24% during recessions back to 1946, according to research from Deutsche Bank.

“If we do not get a recession, we are approaching extreme territory,” Deutsche Bank strategist Jim Reid wrote in a note.

For investors, when the Fed begins to shift towards easing monetary policy, markets have historically reacted positively and quickly – especially if the main reason for their collapse was related to central bank policy, according to Goldman Sachs’ analysis.

What no one is sure about is when exactly the Fed will shift gears, and how much more pressure the economy may come under in the meantime.

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

Navigate the Bear Market

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

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