Your Weekly Update: The Fed's Hope Part Two

Friday saw a selloff that, in my view, hardly discounts the threat of the Brits voting next week to leave the European Union. However, the VIX index, which reflects implied volatility in S&P 500 options (rises when option investors see risk) spiked nearly 17%, Eurozone stocks tanked, Eurozone bonds rallied and the British Pound sank on polls suggesting that the majority of voters favor leaving the union --- now that’s what I’ve been talking about!

So, does this mean that the somewhat pessimistic technical picture for the U.S. market I’ve been illustrating of late will ultimately prove prescient? Perhaps. But keep in mind, this has been a short-term view that might have us hesitating with new cash to allocate, but not have us fret in the least over our diversified long-term equity portfolios. More on that stuff next week.

Today we’re going to explore some business cycle history and consider the possibility that the Fed might be blessed with yet another opportunity to get interest rates to a level that they’ll be able to work with come the next recession.

Here’s your standard business cycle illustration:     click each chart then click again to enlarge...



The move below the center line indicates recession, above would be expansion. The asset class references below the line point to when each typically bottoms in price, those above the line would be where they typically peak. In a nutshell; during contractions, bonds tend to bottom on the way down, stocks at the nadir, and commodities as the economy begins to accelerate into the next expansion. During expansions bonds tend to peak on the way up, stocks peak at the peak, and commodities peak as we decelerate toward the next recession.

Here’s the real world from the mid-90s to now (red shaded areas = recessions):



The arrows point to the peaks for each asset class. Notice that prior to, and between, the past two recessions the asset classes followed the playbook. Notice, however, that since the Great Recession of 2008 things don’t line up like they “should”! I put question marks at possible peaking points for bonds and stocks, but there’s absolutely no maybe when it comes to the latest peak in commodities' prices. Hmm…

Let’s look at the 80s:



Now the 90s:



Now look back at the first real world chart. Notice again how bonds, then stocks, then commodities topped --- leading into and during the 2008 recession. Now look again at the 80s and 90s: We had tops during each expansion that were not shortly followed by recession. And notice how midway through both the 80s and 90s commodities had diverged from the path and didn’t follow bonds and stocks higher while they made their ways to their respective peaks.

Here, I’ll make it easier:

80s:



90s:



Now notice how where we are today looks kinda like the mid 80s and 90s:



Bottom line: History offers the Fed hope that asset class peaks and, in particular, commodity bear markets don't always spell recession. And, thus, there’s a chance that a whole new round of expansion can occur --- allowing them yet another opportunity to get right with interest rates. Time will tell!

Have a great weekend!

Marty