8/31/2023 0 Comments Spy max drawdown![]() ![]() Second, valuations help explain why recent drawdowns during Federal Reserve pivots are worse than those before the dot-com bubble crash. Therefore, it’s not surprising the maximum drawdown during the current rate hike cycle was larger than average. Such is three times the 16% average of the prior eight episodes. From May 2020 to May 2021, the one-year period following the last rate cut, the S&P 500 rose over 50%. There are two other considerations in formulating expectations for what the next Federal Reserve pivot has in store for stocks.įirst, the graph below shows the maximum drawdowns during rate-cutting periods and the one-year returns following the final rate cut. The S&P 500 experienced a nearly 25% drawdown during the current cycle. The average drawdown during rate hiking cycles is 11.50%. The graph below shows the maximum drawdown from the beginning of rate hiking cycles. Since the market experienced a decent drawdown during the rate hike cycle starting in March 2022, might a good chunk of the rate drawdown associated with a rate cut have already occurred? What Percentage Drawdown Should We Expect This Time? The speculation resulting from keeping rates well below the natural rate was palpable. Despite brisk economic activity and rising inflation, the Fed kept interest rates at zero and added more to its balance sheet (QE) than during the Financial Crisis. The second half of 20 provide evidence of Wicksell’s theory. Financial assets skyrocket in value while long-term, cash-flow-driven investments with riskier prospects languish. They borrow heavily at the low rate and buy existing assets with somewhat predictable returns and shorter time horizons. But when short-term market rates are below the natural rate, intelligent investors respond appropriately. Per Wicksell, optimal policy should aim at keeping the natural and market rate as closely aligned as possible to prevent misallocation. If a divergence between the natural and market rates is abnormally sustained, it causes a severe misallocation of capital. ![]() Wicksell viewed the divergences between the natural and market rates as the mechanism by which the economic cycle is determined. Second, Wicksell holds that there is the “market rate” or the cost of money in the economy as determined by supply and demand. The natural rate is the combined growth of the working-age population and productivity growth. Per Wicksell’s Elegant Model:įirst, there is the “natural rate,” which reflects the structural growth rate of the economy (which is also reflective of the growth rate of corporate earnings). The nineteenth-century economist’s model states two interest rates help assess economic activity. Wicksell’s Elegant ModelĪ few years ago, we shared the logic of famed Swedish economist Knut Wicksell. We take a quick detour to appreciate how the level of interest rates drives speculation. While not coming to their side, what was their alternative? Accepting a negative real return is not good for profits. As we are learning, such speculative behavior emanating from Fed policy in 20 led to conservative bankers and aggressive hedge funds taking outsized risks. Speculation often blossoms when interest rates are predictably low. From the pandemic until the Fed started raising rates in March 2022, the 10-year real yield was often negative. The graph below shows that real yields, yields less inflation expectations, have been trending lower for 40 years. Regardless of the reason, higher interest rates helped keep speculative bubbles in check.ĭuring the last 20 years, the Fed has presided over a low-interest rate environment. Indeed, high inflation during the 1970s and early 1980s forced Fed vigilance. As such, they didn’t allow rates to get too far above or below the economy’s natural rate. So why are the most recent drawdowns worse than those before 1990? Before 1990, the Fed was more active. Of the six other experiences, only one, 1974-1977, saw a drawdown worse than the average. The three most recent episodes saw larger-than-average drawdowns. The average maximum drawdown from the start of each rate reduction period to the market trough was 27.25%. Since 1970, there have been nine instances in which the Fed significantly cut the Fed Funds rate. Their conditioning may prove harmful if the past proves prescient. Like Pavlov’s dogs, investors buy when they hear the pivot bell ringing. ![]()
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