We got a lovely gift in December when the Fed suddenly changed its stance as the Bully of Wall Street and announced they anticipated the need to start cutting rates in 2024 at some point. This was a 180-degree change from the Fed’s “higher for longer” threat, which has been their central narrative since Powell’s Jackson Hole speech in August 2022. The problem is that history shows the Fed should have started cutting rates last March.
We have said several times that the Fed could manage interest rate policy better if they just outsourced their decision-making to the 2-Year Treasury Note Yield. Using the yield on the 2-Year would lead to far fewer bubbles and crashes, and the ones we would get would be much less severe. But the inability of the Fed to raise rates soon enough or to cut rates fast enough – no matter how many Ivy League degrees they have amongst them – has led to the continuous boom and bust cycle the market has experienced over the last 30 years.
It is relatively simple to understand: when the Fed rate is below the yield on the 2-Year, the Fed is being too loose with their policy. When the Fed rate is above the yield on the 2-Year, the Fed is being too restrictive with their policy. That is it; no $150K business school education is needed. The chart below shows the difference between the Fed Rate and the 2-Year Yield going back to 1998:
The Fed's delay in raising rates fuels the boom-and-bust market cycle's ‘boom’ up move. This delay is also directly related to the Fed’s stubbornness regarding lower rates, which we are seeing currently. It is much more critical for the Fed to follow the direction of the 2-Year Yield when it begins to fall below the Fed Rate for an extended period. This has occurred four times as well since 1998:
The 2-Year Yield crossed below the Fed Rate in June 2000, but the Fed began lowering rates seven months later in early 2001. It took 9 rate cuts and 14 months before the Fed Rate and 2-Year Yield got back in balance, over that period the S&P 500 dropped by -31%.
The 2-Year Yield crossed below the Fed Rate in June 2006, and in response the Fed waited until September of 2007 to begin lowering their rate. There is little doubt the mistake of not starting their rate cutting cycle sooner compounded the problems of the Financial Crisis. Before the Fed Rate reached equilibrium with the 2-Year Yield in December 2008, the S&P 500 lost roughly -43%.
After raising rates eight times between 2015 – 2018 and trying ‘quantitative tightening’ for the first time, the 2-Year Yield quickly reversed lower in late 2018. The final three months of 2018 saw the S&P drop by -20% before the Fed finally realized its error. It took until July 2019 before the Fed started to cut rates and stop its balance sheet quantitative tightening program.
The economy is now within the fourth occurrence of the Fed remaining too high for too long – will the outcome be different this time? The 2-Year Yield closed out 2023 at 4.25%, a yield between 1.00% to 1.25% below the current Fed Rate target of 5.25%-5.50%. The 2-Year Yield has been below the Fed Rate since early March 2023, almost 11 months now, which should be enough to cause alarms to go off, but we should not underestimate the stupidity of our Fed.
While there have been periods in the past, like 2006 & 2007, when the Fed remained higher for longer, at no time in these past periods has the Fed raised rates when the 2-Year Yield was below their target rate. Moreover, the Fed has maintained its $95 billion per month of quantitative tightening, which has been running at maximum speed for 17 months. At this time, we can only assume the Fed is afraid to embarrass themselves again regarding Inflation and their desire to destroy it, even though their policies caused it.
The outcome of the Fed’s actions, or lack thereof, over the last year, is simple to understand but difficult to accept. The longer they maintain their constrictive policy at this point of the cycle, the more economic damage they will cause. This damage may not show up in the market this year, but at some point, it will matter.
Narrow Market Remains Narrow
For most of 2023, the market was supported by what many call the ‘Magnificent 7’; these are the massive capitalized, earning tech darlings of the last decade. This group of 7 includes Amazon., Apple, Alphabet (Google), Microsoft, Meta (Facebook), Nvidia, and Tesla. In 2023, the average return for these companies was an impressive +110%. An investor should be concerned that these seven stocks represent roughly 30% of the weight in the S&P 500 Index, while the remaining 493 stocks represent 70% of the index. This makes the S&P 500 Index extremely top heavy.
Over the last two months of 2023, more favorable economic data and a more friendly Fed led to a welcomed broadening of the market. At the end of October last year, the average stock in the S&P 500 was down about half a percent. But November and December brought one of the broadest market rallies we have seen in several years, allowing the average return for an S&P 500 stock to jump to 17.50%.
Through the start of 2024, we have been slowly reverting to the narrow market like what we saw for most of last year. Loss of overall market participation can easily be attributed to higher bond yields after their significant pullbacks in late 2023. While a bounce in bond yields should have been expected to start the year, comments by the Fed, which have clouded the potential start of their rate cut cycle, have begun to make bond yields ‘sticky’ again. A healthy market is broad, but we think we will not see a significant expansion in overall market participation (like we saw in 2023) until the Fed provides firm data on their first rate cut.
February Expectations
The election year seasonal pattern for the S&P traditionally represents the 2nd best-performing year of the Presidential Cycle, only trailing the Pre-Election Year. As we race toward the November elections, the S & P typically performs better in an election year when a sitting president is running for re-election vs. an open election.
While the seasonal pattern expects an up year, February is a weak link within the Election Year Cycle. Only the anxiety-filled month of October posts an average weaker monthly performance than February during an election year. So, for February, we expect a split market, stronger earlier in the month but with weakness at the end of the month.
One crucial comment when looking at the performance of the S&P during an election year: Before 2020 and the Covid Crash, the seasonal pattern of the S&P usually saw the market peaking in February, followed by about four months of sideways trading before resuming the move higher. The Covid Crash has skewed the data to a point, but some of our other data points are showing us to expect a short-term trading top around the 15th and consolidation into the end of the month. This is only a consolidation period of the gains from the last few months, and we expect that the weakness will lead to a higher market over the coming months.