Learning from History: How to Invest in U.S. Stocks During the Federal Reserve's Rate Cut Cycle?

The Federal Reserve's interest rate cuts in 2024 have once again sparked a familiar debate among investors: Will the easing cycle extend the economic expansion period or signal an impending economic recession?

History can serve as a guide for investment. Past cycles reveal how monetary changes affect economic recessions, bear markets, and the dominance of investment styles. Given that inflation remains a threat, the Fed's next actions have tangible implications for investment portfolios. This article assesses the relationship between the Fed's interest rate cycle and various market dynamics by studying historical data.

In the past 10 interest rate cut cycles, 2 successfully avoided economic recessions. If the current cycle can also avoid a recession, then the 2024 rate cut cycle will be the 3rd out of 11. Whether during recessionary or non-recessionary periods, stock style performance after rate cuts has been extremely varied.

Since 1965, in 12 interest rate hike cycles, the U.S. has experienced 10 instances of yield curve inversion and 8 economic recessions. If the current inversion persists, an economic recession will be unavoidable. The only instance of inversion that did not trigger a recession occurred during the 1966 rate hike cycle (similar to the current period), when the fiscal deficit as a percentage of GDP was about 3%, comparable to the fiscal expansion of about 3% over the past four years.

Of the nine yield curve inversions, eight occurred before economic recessions, with the time span from yield curve inversion to market peak ranging from 2 to 15 months. Currently, the U.S. Treasury yield curve has been inverted for 35 months.

There was one instance of yield curve inversion (in 1966) that did not lead to an economic recession. At that time, as the yield curve normalized, growth, high beta, and quality styles led market performance, similar to the current situation.

The following chart shows stock market performance during three different time periods after the Fed's first rate cut: the 1st to 12th months, the 13th to 24th months, and the 25th to 36th months. Although the overall return is usually positive, the lack of consistent patterns across the weeks indicates that outcomes largely depend on the specific macroeconomic environment during each easing cycle.

The following chart illustrates the historical relationship between the Fed's rate cut cycles, economic recessions, and bear markets. Analysis of 12 different cycles indicates that in 10 rate cut cycles, the Fed began cutting rates only after the stock market peaked, suggesting a lag in its policy response. Additionally, the National Bureau of Economic Research (NBER) typically confirms a recession only 4 to 21 months after it has actually begun. It is noteworthy that since the highly volatile monetary environment of the 1970s, the Fed has more frequently begun cutting rates before officially confirming an economic recession

As for the performance of various investment styles after the Federal Reserve's interest rate cut cycle begins, data shows that the returns exhibit a complex and diverse pattern, highlighting the uniqueness of each cycle. A reasonable explanation for this disparity is that monetary easing policies do not always align with stock market cycles, sometimes leading to divergences in the performance of different investment styles. There seems to be no correlation between the interest rate cut cycle, economic recession, and market risk behavior, making the sustainability of investment styles difficult to predict.

Since 1965, there have been 12 different interest rate hike cycles, of which 8 ultimately led to economic recessions, 10 were preceded by an inverted yield curve, and 9 coincided with bear markets. The median duration of these cycles is 18 months, ranging from 12 to 39 months, while the median increase in the federal funds rate is 3.75%, with a range of 1.75% to 13%. The median time from the start of the interest rate hike cycle to the market peak just before the economic recession is 22 months, ranging from 4 to 51 months.

In most interest rate hike cycles, the Federal Reserve continues to tighten monetary policy even after the stock market reaches its peak. This pattern reinforces the long-held adage that bull markets do not end due to the passage of time, but rather due to the actions of the Federal Reserve. While this tough stance often leads to economic contraction, there are times when the Federal Reserve attempts to alleviate recession pressures in advance.

Of the eight economic recessions observed since 1965, the Federal Reserve began lowering interest rates before the economy officially fell into recession in five instances, indicating that it took proactive policy adjustments aimed at alleviating economic pressure. However, these five cases show that early rate cuts do not always prevent economic recessions, highlighting the limitations of monetary policy when overall economic momentum begins to deteriorate.

In the year following the end of an interest rate hike cycle, the performance of different investment styles varies, reflecting the cyclical characteristics of monetary policy and its market dynamics. This disparity is likely due to the fact that the monetary policy cycle does not always synchronize with the stock market cycle For example, in the 1970s, the Federal Reserve often shifted directly from raising interest rates to lowering them, making it difficult to distinguish between returns after rate hikes and returns after rate cuts.

A persistent historical phenomenon is that high beta stocks often perform the best or the worst, while value and quality stocks tend to outperform the average and are rarely among the worst performers. This phenomenon continues to exist after the end of a rate hike cycle.

In the past 12 notable monetary tightening cycles, 10 were accompanied by an inverted yield curve. Among these 10 inversions, 8 subsequently led to economic recessions, highlighting the predictive ability of the yield curve as a leading economic indicator.

Yield curve inversions typically coincide with economic recessions and bear markets. The relationship between yield curve inversions and market peaks varies significantly, ranging from 12 months before the inversion to 15 months after. This variability underscores the complexity of the market's response to changes in monetary policy.

Two rate hike cycles—1984 and 1995—are exceptions, achieving a "soft landing" without an inverted yield curve or triggering an economic recession. In contrast, the rate hike cycles of 1966 and 2022 experienced yield curve inversions but avoided economic recessions. Analysis indicates that the absence of a recession was due to highly stimulative fiscal policies. However, this policy backdrop ultimately led to the recession and bear market of 1968.

There are similarities between the fiscal environment of the mid-1960s and the current economic situation. In both periods, high deficit spending has stimulated economic activity. The reversal phenomenon that began in 2022 is the longest and third most severe in terms of duration and intensity. Despite these adverse signals, the U.S. economy and labor market have shown remarkable resilience.

Consistent with the previous two scenarios, the performance of various investment styles in the year following a yield curve inversion shows significant differences, highlighting the cyclical characteristics of monetary policy and market behavior. A yield curve inversion may indicate that the market is entering the later stages of the economic cycle. In this environment, it is not surprising to observe that quality and growth stocks outperform other sectors, as these sectors typically perform stronger in the later stages of the economic cycle, with resilient earnings. **

The historic interest rate fluctuation cycle of the Federal Reserve indicates that its policy responses always exhibit a certain lag relative to turning points in the market and economy, highlighting the "long and variable lags" in monetary policy. An inverted yield curve has proven to be a reliable indicator of economic recession, but the timing of its occurrence and its impact on the market remain variable, complicating forecasting efforts.

For investors, statistical data shows that no single policy adjustment can provide clear operational guidance. The outcomes of interest rate cuts vary greatly, underscoring the importance of considering policy statements in conjunction with the economic backdrop. During a rate hike cycle, allocations to value and quality assets typically yield more stable returns, while high beta coefficients often lead to significant gains and severe losses. After periods of inversion, growth and quality assets tend to dominate, with high beta coefficients also offering upside potential, but with increased risk.

The weight of history suggests that investors should view the current easing cycle from the perspective of the late stage of an economic recession. In 1966, fiscal expansion drove economic growth, allowing the economy to avoid recession. A similar situation exists today. If this similarity holds, portfolios leaning towards quality and growth styles may continue to perform well, while exposure to high beta coefficients within various styles of investment may be favored.

Meanwhile, inflation remains a key factor: if inflation rises again, it may force the Federal Reserve to reimplement tightening policies, which historically often leads to a challenging market environment. For investors, the immediate priority is to prepare for market volatility while also being ready to adjust strategies in response to potential policy changes