Emotional Rescue: Markets, Fed Policy, and Elections

The March Federal Open Market Committee (FOMC) meeting is this week and although there is no expectation the committee will cut interest rates, there will be the release of the updated “summary of economic projections” (SEP) as well as the "dot plot" showing the collective committee member forecasts for the fed funds rate. As of this writing, the probability—per the fed funds futures market—of a rate cut at the May FOMC meeting has fallen from nearly 30% a month ago, to only 10% today. For the June FOMC meeting, the probability is about a coin flip. As such, for now, the Fed remains in "pause" mode (the period between the final hike in a cycle and the first cut). We debuted the table below in our 2024 outlook report, and it's chock-full of stock-market-related performance throughout historical (and full) Fed cycles.

Warning: Beware of generalities in terms of market behavior when it comes to Fed cycles. There are only 14 historical cycles—a.k.a. a small sample size. In addition, as shown via the red and green boxes, there are wide ranges historically. A small sample size, along with a wide range of outcomes, evokes the old adage, "analysis of an average can lead to average analysis."

Many assume that once the Fed has finished hiking rates in a cycle, it's smooth sailing for stocks. But history shows that in the six-month period following the final hike in a cycle, the S&P 500 was up only 36% of the time, had average and median returns in negative territory; but importantly, showed a range from -18% to +20%. The odds improved a year after the final hike, but only jumped to 43%; and although the average return bumped into positive territory, the range was enormous, from -29% to +32%.

Moving to the middle column in the table above, the range of days during which the Fed was in pause mode was as short as 58 days in the late 1950s and as long as 874 days in the early 1980s. As such, an average of 231 days tells us nothing (especially given that only one historical range even had a 2-handle on it). More remarkable is the following column, showing the S&P 500's performance during the pause period. The average and median showed flattish returns, but that's largely useless information. The percentage positive was exactly 50%, meaning there were seven up moves and seven down moves, with a massive range from -27% to +26%.

Perhaps helping to explain the obsession with the timing of the initial rate hike, you can see in the table above that it wasn't until the Fed started cutting, that the averages/medians/ranges were more compelling. That said, as we've noted before, the exact timing of the cut isn't as important as the nature of the cut—notably, whether it's the start of a fast or slow cutting cycle. Barring any major economic shifts, as of now, the Fed has telegraphed—and the economic data have been supportive of—a slow cycle. In particular, that likely bodes well for cyclically oriented sectors.

As shown in the chart below, courtesy of our friends at Ned Davis Research, broad cyclicals (Energy, Materials, Industrials, Consumer Discretionary, Financials, Technology, and Communication Services) tended to outperform defensives (Consumer Staples, Health Care, Utilities, and Telecom Services) in slow cutting cycles—shown via the black line. Conversely, the opposite occurred in fast cutting cycles, as cyclicals didn't start doing well until about nine months after the first cut—shown via the orange line.

Interestingly, since the Fed's last hike in July 2023, cyclicals have been outperforming, with Communication Services up the most (+22.3%), followed by Information Technology (+20.2%) and Financials (+14.4%). The only sector that has fallen is Utilities (-8%). That's not in keeping with what has historically happened leading up to the first cut, as shown in the far-left panel in the chart above.

We continue to remind investors that fast cutting cycles are often due to recessions. The three most recent Fed cutting cycles—which started in 2019, 2007, and 2001—were all fast in nature and followed by both bear markets and recessions. Barring any major deterioration in the economy (especially on the services side), we continue to think the market can digest the start of the cutting cycle, especially if it's not accompanied by a significant deterioration in economic growth.

Aside from Fed policy, the other significant uncertainty this year surrounds the November elections. We are not political prognosticators, so we'll keep this section short and fact-based (imagine that). There are so many ways to slice and dice stock market behavior around election outcomes, but here are a few charts that lay out the history of stock-market gains (and/or losses) throughout the post-1900 history of elections.

The charts below are courtesy of Ned Davis Research and use the Dow Jones Industrial Average vs. the S&P 500 because the former has a longer history. Starting with presidential elections, the stock market has performed slightly better under Democratic presidents.

Of course, there is also Congress to analyze when it comes to political party and market performance. As shown below, the best performance has come with Republican control of Congress, with the worst coming when Congress was split between the two parties.

Combining the two, the chart below looks at the six possible combinations in terms of the presidential and congressional party breakdown. The best performance has occurred when there was a Democrat in the White House and a split Congress (the current configuration), but full Republican control a close second. The two worst (both with negative annualized returns) outcomes historically were under Republican presidents and either a split Congress or a Democratically controlled Congress. As an aside, the two most common outcomes (last column in the table below) were when there was full party control, a very unlikely outcome this year.

The final chart comes from Schwab's own chart library and frankly sends the most appropriate message for investors who think trading around election outcomes makes sense. Covering the modern period for the S&P 500, investing only when a Republican was in the White House, a $10K initial investment in 1961 would have grown to more than $102K by 2023. On the other hand, the same $10K initial investment would have grown to more than $500K, investing only when a Democrat was in the White House. Some might stop the analysis there and conclude that staying out under Republican presidents and being in under Democratic presidents is a winning strategy. But the real moral of the story is told with the final bar. The same $10K initially invested in 1961 would have grown to more than $5.1M by just staying invested, without regard for the political party in power.

This is going to be an emotional year, certainly as it relates to a contentious and unprecedented election, but also uncertainty around inflation and Federal Reserve policy. There is no more important place to keep emotions out of the mix than with regard to investing. This is a time for discipline, as well as trying to assess whether there is a narrow or yawning gap between your financial risk tolerance and your emotional risk tolerance. The psyche of investors can overwhelm rational thinking during periods of stress in the markets, or stress in our own views. Stay the course.