NEW YORK – The Federal Reserve's job, its longest-serving chairman once said, is to “take away the punch bowl just as the party gets going,” and that's exactly the message Wall Street took from comments by current Chair Jerome Powell this week.
Stock prices tumbled after Powell said the Fed may halt its immense support for financial markets sooner than Wall Street expected. History suggests, however, that stocks aren't always losers when the Fed pulls back its help.
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Some economists and investors were already calling for just such a move given the economy's strong recovery from last year's brief recession and the stubborn persistence of high inflation that's sweeping the world.
But the S&P 500 sank 1.9% in one day after Powell said the Fed's monthly purchases of bonds, which recently began shrinking from $120 billion, may end months sooner than the June target it had been on pace for. Added to worries about the new coronavirus sweeping the world, it caused Wall Street's so-called “fear gauge” to rise sharply.
Wall Street has reason for concern. An early halt to the Fed's bond-buying program, which has helped keep long-term interest rates low and thereby supports the economy, would open the door for the central bank to make the more impactful decision to start raising short-term interest rates.
Those have been pinned at a record low near zero since early in the pandemic, one of the major reasons the S&P 500 has roughly doubled since hitting a four-year low in March 2020. Low rates are also a main reason many investors have brushed aside worries that stock prices have climbed too high, too fast.
An investor buying a 10-year Treasury, for example, is looking at a yield of just 1.44%, not even keeping up with current inflation levels.
“As long as the 10-year stays below 1.50%, there is no alternative” to buying stocks, said Josh Wein, portfolio manager at Hennessy Funds.
To see how that's lifted Wall Street, consider what investors are paying for each $1 of corporate earnings. The S&P 500's price is trading at close to 24 times the earnings per share its companies have produced over the last 12 months, according to FactSet. That's more expensive than its average price-earnings level over the last two decades of slightly less than 18.
But stocks could keep rising even after the Federal Reserve begins raising interest rates. Usually, such rate hike campaigns occur when the U.S. economy has enough strength to stand on its own, without assistance from the central bank. And that in itself can push corporate profits, the lifeblood of the stock market, higher.
Since 1983, the S&P 500 has had a positive return in the 12 months following the start of a rate-hike campaign in six of seven occurrences, according to BofA Global Research. The average return was 6.1%.
Broaden the time horizon to two years following the first rate increase, and the S&P 500 still had a positive return in all but one of them.
To be sure, that one exception has a similarity with today's market, according to Savita Subramanian, equity strategist at BofA Securities. The S&P 500 was much more expensive than normal in 1999, amidst the dot-com bubble, with S&P 500 prices trading at 30.5 times their earnings.
The historical record of U.S. stocks' performance when the Fed slows its bond purchases is not as deep. That's because such bond-buying programs have only become a routine part of the central bank's toolbox since the 2008 financial crisis.
Stocks did struggle a bit in the summer of 2013 when then Fed Chair Ben Bernanke suggested it could begin slowing, or tapering, its bond purchases. That caught investors by surprise, and the ensuing mini-swoon for the market came to be known as the “taper tantrum."
But stocks nevertheless quickly got back to rising. The Fed didn't end up raising short-term interest rates until late 2015, more than two years after the taper tantrum.
“While some worry that the end of tapering accelerates the point at which interest rates rise, I don’t believe that will happen, although this fear of higher rates adds to market jitters in the short-term,” said David Bahnsen, chief investment officer at The Bahnsen Group.