The Fed increased the fed funds target rate for the third time in 11 years on Wednesday, March 15. (It could also be said that the Fed has hiked rates three times since December 17, 2015.) The bottom line is that the Fed has embarked on a rate hiking cycle. To be clear: the Fed is no longer providing additional stimulus and can't be described as stimulative. Rather, given the slow pace of the most recent hikes and the relatively stable level of the Fed's balance sheet, we'd currently rate the Fed as neutral. Nonetheless, this is a "huge" change in the character of the economic operating environment, as the bull market, to date, has been carried largely on the back of Fed stimulus.

The rate hikes are expected to continue, with the Fed (and the markets) projecting at least two more hikes this year, with the Fed funds eventually reaching 3% by the end of 2019.

The question is, "Are the rate hikes the death knell for the bull market?"

The table below, courtesy of Ned Davis Research, provides some thought-provoking information concerning rate hikes. Looking back to 1919, NDR has identified each time there have been three rate hikes, or three rate hike-like equivalents (discount rate increases, margin increases and reserve requirement increases all counted as restrictive actions by the Fed).

There is an old market saying that after three rate hikes, the market stumbles, i.e., the "Three Steps and a Stumble" rule.

To test this theory, NDR identified the value of the Dow Jones Industrial Average on the date of the third hike, and then looked out over the next 6 months. They then pinpointed the market's lowest level during that six-month period. As you can see on the table below, typically, the market declined an average of -6.8% (mean), with the lows happening an average of 48 market days after the third hike. The declines ranged from -0.1% to -24.8%.

The smallest drawdowns (declines) were in 1989 and 1994. In both instances, the markets dipped within a few days and then kept moving higher. In 1989, the decline was -0.1% and occurred three days after the third rate hike. Then the market continued to grind higher. However, by December (which was just outside of the study's six-month analysis period) the S&L crisis was in full bloom, and by July 1990 the U.S. was in an official recession.

The 1994 decline was -0.6% and occurred just two days after the rate hike. The U.S. economy was squarely in the Clinton growth phase, with GDP growth around 4%, unemployment at 5.5% and inflation at 2.7%. It wasn't until 1998 and the LTCM crisis that the markets stumbled. If I had to point to a period where the Three Steps and a Stumble rule didn't work out, this would be it. The inflating technology bubble, global growth, and the coinciding growth in the U.S. economy were enough to offset the Fed's rate hikes and rising interest rates.

There is another facet to the NDR table that is instructive, and which I find particularly fascinating. NDR has also identified the subsequent bear market lows following each of the third rate hikes. In other words, following a third rate hike, NDR figures out the lowest level the DJIA reaches during the next bear market.  Keep in mind, some of the subsequent bear markets don't occur for years. For example, following the 1994 "Clinton growth phase" third rate hike, the DJIA continued to go much higher and then entered a bear market.  That bear market low was still much higher than where the DJIA was on the date of the 1994 third hike. But this result, based on the table, is unfortunately, an anomaly.

In fact, more often than not, the next bear market lows hit levels that were well below where the DJIA was on the date of the third rate hike. The table shows that, on average following a third rate hike, the market eventually went to levels that were -12.0% lower over an average of 465 market days.

The two most recent examples, 1999 and 2004, show that the DJIA eventually hit levels that were -24.7 and ‑27.1% lower, respectively. And those levels didn't occur until 462 and 1,111 market days later. My view is that this study indicates that the beginning of rate hike cycles should be taken seriously as potential disruptors to bull markets.

Ned Davis Research, Inc.
  • Report Name = T_525.RPT
  • Run Date = 10/04/2011
Dow Jones Industrial Average Performance After Three Steps and A Stumble Sell Signals
11/03/1919 - 10/03/2011
  Decline to Near-term Low Decline to Bear Market Low
Signal Date Percent Days Percent Days
11/03/1919 -24.8 92 -46.6 540
07/13/1928 -1.3 2 -4.4 396
05/01/1937 -15.5 120 -43.3 273
01/21/1946 -5.4 28 -17.0 378
08/13/1948 -4.7 81 -10.0 239
09/09/1955 -7.6 22 -11.5 533
03/06/1959 -1.3 16 -7.1 415
12/06/1965 -8.0 113 -20.8 213
04/19/1968 -3.1 69 -29.7 502
05/04/1973 -10.7 76 -39.4 403
01/09/1978 -5.4 35 -5.4 35
12/05/1980 -5.0 4 -18.8 425
02/24/1989 -0.1 3 5.3 412
04/18/1994 -0.6 2 108.2 1104
11/16/1999 -10.4 76 -24.7 462
09/21/2004 -4.8 24 -27.1 1111
  --- --- --- ---
Mean -6.8 48 -12.0 465
Median -5.2 32 -17.9 414
A near-term low is the DJIA's lowest close within a 126 market day period following a sell signal. A bear market low is the first NDR-defined bear market low following a sell signal. Discount rate, margin, and reserve requirement increases all qualify as steps unitl 1993, then Fed Funds Targe rate. Days = Market Days.

T_525 10/04/2011

Clearly there are other considerations. For example, the current rate hikes are coming off of a 0% base, and are considered by many investors to be a "normalization" of rates, as opposed to the Fed taking a restrictive stance to tamp down inflation and ultimately economic activity.

However, I think the point now is whether U.S. and global economic growth, buoyed by fiscal stimulus, is going to be enough to pick up where monetary policy left off.

With that in mind, take a look at the next NDR table. It illustrates the growth rate of real GDP during the past eleven U.S. economic expansions since 1949. As you can see, the average annual GDP growth rate during each expansion has been steadily declining. In fact, the latest real GDP growth rate of 2.1% is well below the average of 4.4% seen during all expansions (also note that this is the third-longest expansion). There is a reason the Fed had to keep rates near 0%—economic growth just hasn't been that good.

Ned Davis Research, Inc
  • Report Name = T_600A.RPT
  • Run Date = 03/01/2017
Anatomy of Post War Economic Expansions
03/31/1947 - 12/31/2016
Beginning Date Ending Date Percent Gain Percent Gain/Annum Days
10/31/1949 07/31/1953 28.6 6.9 1369
05/31/1954 08/31/1957 13.6 4.0 1188
04/30/1958 04/30/1960 11.5 5.6 731
02/28/1961 12/31/1969 52.0 4.8 3228
11/30/1970 11/30/1973 16.0 5.1 1096
03/31/1975 01/31/1980 23.3 4.4 1767
07/31/1980 07/31/1981 4.4 4.4 365
11/30/1982 07/31/1990 38.4 4.3 2800
03/31/1991 03/31/2001 42.6 3.6 3653
11/30/2001 12/31/2007 18.0 2.8 2222
06/30/2009 12/31/2016 17.1 2.1 2741
---------- ---------- ---------- ---------- ----------
Mean   24.1 4.4 1924
Median   18.0 4.4 1767

Growth of Real Gross Domestic Product

T-600A 03/01/207

There are many reasons for this, including demographics, technology commoditizing many industries, political uncertainty restraining capital investment, etc., but perhaps one of the most important reasons is illustrated in the next chart:

Federal Debt as a Percentage of GOP.

That's right: the high level of debt is restraining economic growth.

The last NDR table I'll feature today is below. It shows that, for the current expansion period from 6/30/2009 through 9/30/2016, the GNP/Debt ratio is 0.38%. This means for every dollar of debt that had been borrowed during the expansion, only $0.38 cents of economic growth had been created. This is much lower than the average of $0.65 cents of economic growth that had been averaged since 1961. This is heading in the wrong direction.

Ned Davis Research, Inc.
  • Report Name = T_620.RPT
  • Run Date = 03/09/2017
Debt-Financed Expansions
03/31/1961 - 09/30/2016
Increase in GNP
(billions $)
Increase in Debt
(billions $)
03/31/1961 - 12/31/1969 497.30 613.34 0.81
12/31/1970 - 12/31/1973 395.90 484.42 0.82
03/31/1975 - 03/31/1980 1203.60 1626.54 0.74
09/30/1980 - 09/30/1981 399.40 415.87 0.96
12/31/1982 - 09/30/1990 2614.70 6144.85 0.43
03/31/1991 - 03/31/2001 4454.30 7986.87 0.56
12/31/2001 - 12/31/2007 4088.80 13117.48 0.31
06/30/2009 - 09/30/2016* 4414.20 11612.27 0.38
Median     0.65
* Most recent data available
Expansion currently underway
T_620 03/09/2017

Bottom Line: The third rate hike isn't necessarily an immediate death knell for the bull market. However, if the Fed does persist in fighting inflation and moves past "normalizing rates" to being restrictive, it has nearly always ended badly. At the least, one would expect, based on this data, that a better buying opportunity will avail itself in the future.

To keep this bull market alive, economic growth will have to improve, and corporate earnings will have to follow suit. At this point, earnings growth expectations are very high, while economic growth projections are being reduced. This tells us that fiscal policy (the Trump policies) will have to come through or markets will react by going lower to reflect economic reality versus fiscal hopes.

At this juncture in the market, even with our portfolio achieving strong results in 2016, we are slightly bullish in our equity allocation.

We are most certainly looking forward to putting our cash to work. Not only do we increase our potential return, but our view is that historically, when the process gives the all clear to add exposure, it's not just an all clear for buying more stocks, but an indication that the global business environment is likely improving—and that's good for everybody.

Until that time, we will continue to manage risks, which, based on the level of our portfolio's cash holdings, are relatively lofty.

If you have any questions or would like more detail, feel free to call anytime.

Have a wonderful week,
Donald L. Hagan, CFA

— Written 3-24-2017

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