On the first of each month, I share reflections on the market in our private podcast. This enables me to tie together the various threads of our work and connect the dots between what I observe and hear during my travels and interactions with people. 

While many of you are podcast buffs, some prefer the magic of the written word. This is an edited transcript of the recording, without my typical writing flair. Here goes:  

Now that it has been three months since the last Fed rate hike, we can begin to contemplate what comes next. But first we need to assume the right analogy or starting point.

Rather than following in the footsteps of his revered predecessor, Paul Volcker, we believed Fed chairman Jerome Powell was emulating Alan Greenspan’s activist monetary policy approach from 1994. Let me remind you. 

Between February 1994 and February 1995, the Fed raised its benchmark short-term interest rate by three percentage points, from 3 percent to 6 percent, to slow the economy and forestall the risk of inflation. Officials thought they were “behind the curve.” 

Speaking to his colleagues, Greenspan also said that he supported higher interest rates because he “very consciously and purposely tried to break the bubble and upset the markets in order to break the cocoon of capital gains speculation.”

Individuals, for example, invested a record amount in stock and bond mutual funds in 1992 and 1993. Gross fund purchases totaled $876 billion in those two years, nearly equaling the total amount purchased from 1970 to 1989.  

Gary Shilling, who ran his own economic consulting firm, predicted that by the third quarter, the US economy would be in recession. “I’ve been through enough recessions to know you can go from strength to recession so fast that you need to ask them to rewind the tape so you can see it again,” he said. 

That didn’t happen. Employment, output, and spending all grew briskly through much of 1994. The average 30-year fixed mortgage rate rose by around 2 percentage points in 1994, ending the year above 9 percent. Yet home prices continued to rise throughout the surge in rates.   

In twelve months, the Fed had unexpectedly doubled its main policy rate to 6 percent. Bonds lost $1 trillion in value. The 30-year Treasury bond fell more than 20 percent. It was the worst bond selloff in more than sixty years. The 10-year yield peaked at slightly over 8 percent, a level it would never approach again. Never. 

Surprisingly, after losing 10 percent from its January 1994 peak, the S&P 500 had already bottomed out on April 4—before the first 50 basis points rate hike. That was the lowest point despite 225 basis points of rate hikes still to come. In a volatile year, the S&P 500 inched up 1.5 percent.  

Compare this with today. Long-dated US bonds lost 39 percent in 2022. Despite 500 basis points in rate increases since March 2022, however, the S&P 500 is down only 2 percent. And like in 1994, perhaps the most surprising economic development over the past year has been that house prices have risen despite a big jump in mortgage rates.

The Fed raised interest rates by a final 50 basis points on February 1, 1995. The decision wasn’t as straightforward given that Greenspan felt they had attained “price stability nirvana.” By the summer of 1995, however, it was clear the Fed had overshot. 

Manufacturing production had flatlined. Retail sales growth slowed from an annual rate of 9 percent in 1994 to 3 percent by the middle of 1995. The average number of private-sector jobs added each month dropped from over 300,000 at the end of 1994 to barely 100,000 by the middle of 1995. The jobless rate stopped falling, and the number of Americans filing initial claims for unemployment insurance grew on a sustained basis for the first time since the 1991 recession.

So In July 1995, just five months later, the Fed reduced interest rates by 25 basis points. The decision was not fueled by a looming recession or increasing unemployment. It was simply a mid-cycle adjustment. Inflation was under control and downside risks to the economy were on the rise. Former Fed Vice Chairman Alan Blinder, who led the charge for lower rates in 1995, admitted that “we got a little hyper-excited.” 

This is the important bit. The S&P 500 actually increased by 16 percent between the Fed’s pause in February and the rate cut in July. So it wasn’t like stocks were falling which caused the Fed to panic. We have come to believe that this is what must happen for the Fed to signal a clear end to the current tightening cycle and perhaps lower interest rates. But it doesn’t have to be the case as we saw in the 1995 experience. 

The Fed would cut rates by another 25 basis points in December 1995 and January 1996 and then hold them steady for a year. The Fed accomplished a soft landing in this fashion. The economist Ed Hyman said that the three-cut series was the “magic sauce in the 1990s to get growth to stop slowing.” In the year following Greenspan’s first “insurance” cut, the S&P 500 soared 21 percent. 

This is kind of the playbook we expect going forward. We still don’t anticipate a recession. But think that the Fed can deliver some insurance cuts next year to refocus on growth after inflation has subsided. This would be a bullish signal, and it would be foretold by declining bond yields.

In 1995, the 2-year yield fell 80 basis points after the Fed’s pause in February which led to the rate cut in July. We therefore believe we are close to the end of the move higher in bond yields. The 10-year yield between 5 and 5.25 is an attractive level. 

Now think about the economy. For all the discussion of headwinds facing consumers — recession worries, higher borrowing costs, the restart of student loan payments — the reality is that the unemployment rate remains extremely low, and wages are rising a bit faster than inflation. 

There’s a lot of focus on the economic impact from pandemic savings. Some argue those savings are running out so a recession is getting closer. I think far more important is the wealth effect since the pandemic which is more sustaining. 

The latest Fed’s Survey of Consumer Finances revealed that the median US household had a net worth of nearly $193,000 in 2022, up from an inflation-adjusted $141,100 in 2019. Measures of “financial fragility” were down. The median debt payments as a share of income fell to 13.4 percent, the lowest seen in the 33-year history of the survey.

We keep underestimating the resilience of the US consumer and economy. Retail sales rose by 0.7 percent in September, on a seasonally adjusted basis, more than twice as fast as economists were expecting. Over the July through September quarter, retail sales rose at a blistering 8.4 percent annual rate. So start thinking in terms of wealth and not purely savings. 

Onto markets. The entire AI build-up so far has happened during a rate hike cycle. What do you think would happen if rates were to be cut next year?  

The S&P 500’s forward PE reached 20 in July and is at 17.5 now. Can we return to 20 with the Fed delivering insurance cuts? I think so. The S&P 500’s forward earnings bottomed in January at $227. Now the estimate for the next twelve months is $242. Combining the two you can see how we can get to new highs in the coming year. 

With all sorts of risks rising I turned to Peter Bernstein, an economist, historian, and investment thinker who has authored some classic books like Against the Gods and Capital Ideas. This is what he said during the 1990s. 

“I come from an earlier generation. My experience reaches back into the Depression, which was very scary, so I am naturally conservative. I came to Wall Street at a time when stocks were considered risky assets. That is why until the late 1950s, investors demanded that stocks offer higher dividend yields than bonds… There is today a new perception, driven by people younger than I am with different memories and experiences, who believe that stocks are in the long run riskless and that it doesn’t really matter how much you pay for them.”

Bernstein also pointed out the importance of a wall of worry for the stock market to climb. Many bull markets are generated from a realization that a lot of bad things we thought were going to happen didn’t happen. That remains the pattern today. A lot of our fears have not come to pass. At the end of 2021, all the good news was in the market. Today, could it be that all the bad news is in the market?  

A final note on politics. I revisited the Durants given the recent events in the Middle East. I was reminded that war is one of the constants of history. Peace is an unstable equilibrium, which can be preserved only by acknowledged supremacy or equal power.

The causes of war are the same as the causes of competition among individuals: greed, aggression, and pride; the desire for food, land, materials, fuels, mastery. The Durants believed that until our states become members of a large and effectively protective group they will continue to act like individuals and families in the hunting stage. The earth will unite as one only if or when there is interplanetary war.