Don't Fight the Fed?

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Back to reality
Back to the here and now
--Soul II Soul

"Don't fight the Fed" is an oft repeated Wall Street mantra. John Hussman observes that it is more urban legend than truism. While comparing periods of Fed easing to Fed tightening indeed indicate higher average returns during the easing periods, those easing periods are also associated with the largest drawdowns.

Since 1940, the maximum drawdown during favorable monetary conditions has been 55% compared to 33% during unfavorable conditions.

The mechanism may be something like this. Fed intervention early in the easing cycle brings about stock market gains. The inflation increases confidence among market participants that the Fed has created permanent prosperity and has their backs in times of trouble. This drives market participants to bid stock prices to what Dr J calls 'overvalued, overbought, and overbullish' conditions.

At some point, the fundamental backdrop weakens to the point where investors realize that their euphoria has been misplaced. Hard selling commences.

Currently, his overvalued, overbought, overbullish indicators are so extended that Hussman suspects that we're close to the point in the cycle where that big drawdown is likely to begin.

Parenthetically, this is one more reason why the argument that the Fed's actions reduce market volatility is so ludicrous. Fed intervention invites risk-taking that would not have occurred in the natural rhythm of the market. Its actions jack prices artificially high, and then, like gravity, natural forces pull them back toward reality.

position in SPX