Fed Cuts, Recessions and Stock Market Performance

Time to Read: 7 minutes

In our latest webinar we discussed all the media coverage around a potential recession in the United States. In that presentation, we featured a version of the table below. which is Ned Davis Research’s (NDR’s) Recession Watch Report. The table features ten key indicators that have historically been indicative of an upcoming recession in the United States. When an indicator moves beyond the key recession level, it turns red. Once at least half of the indicators have reached their key recessionary levels, NDR would likely conclude that the economy has approached a downturn.

*Source Ned Davis Research

As you can see, only one indicator, the Conference Board’s CEO Confidence Index, is red, which is likely due to the ongoing trade war with China. While we plan to keep a close eye on this report, it does not look like the US is in imminent danger of a recession.

Even so, next week the Federal Reserve is widely expected to cut short-term interest rates at the September 17-18 FOMC meeting to keep the economy expanding. We thought it would be useful to look at the US stock market performance around a second rate cut. As you can see from the chart below, second rate cuts have been good for the market, on average. The stock market has responded positively to the second cut, jumping an average of 20.3% one year later.NDR also broke down the performance into two other buckets-(1) a second cut with a recession in the next year and (2) no recession in the next year.  The chart below show our current case in yellow and then the two other buckets in red and blue.  You can see that the performance for both of these scenarios is very similar, with gains being slightly stronger during recessions.The performance does vary dramatically within the recession category depending upon when in the cycle the Fed starts to cut rates (see chart below). When the Fed began to cut rates near the beginning of a recession, the second cut did not help much, especially immediately afterward. The DJIA managed to stay positive with a gain of 0.76% one year later, on average. The weakest stock market performances have come when the Fed tried, and failed, to prevent a recession. The failure of monetary policy to prevent a recession yielded a predictable outcome: the DJIA fell an average of 10.8% one year after the second cut. The fact that the last two easing cycles, in 2001 and 2007, fall into the pre-recession category illustrates the limits of monetary policy in the face of market and economic bubbles.

Since the US economy is almost certainly not in a recession today, the historical studies provide two very different outcomes. If the economy is able to avoid a recession, the average gain is 18.2%. The other possibility is that the economy enters a recession in the next 12 months, in which case the average loss is -10.8%. We will be watching the message of the markets and economy over the coming weeks to see which path looks most likely, and will respond accordingly.

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