This One Number Will Tell You When the Market’s Reality Check Is Here

Shah Gilani|April 7, 2023

A lot of traders and investors are increasingly optimistic stocks can continue to rise, even into solid bull market territory, if the Fed pauses and begins cutting rates in the second half of 2023.

That’s a big “if” and a dicey bet.

Sure, there are lots of reasons to believe the Fed will cut rates, most of which center around “they’ll have to.”

Bullish traders believe the banking crisis hitting a slowing economy will dampen demand and force the Fed to pause as a rapidly approaching recession points to a Fed “overshoot” and a hard landing, which will necessitate rate-cutting early in the second half of this year.

The prospect of rate cutting is driving frontrunning by traders who’ve been buying tech shares, which were hit the hardest as rates were rising and are expected to be the biggest beneficiaries of cuts.

Thanks to them, the market is inching higher, and their optimism could, in fact, kick off a melt-up and a full-blown rally. But I’m telling you right now that you shouldn’t trust it. The case for the Fed not pivoting is much stronger than the case for rate cuts, and the reality is, it’ll be at least another year before it becomes a real possibility.

In the meantime, we’re going to see the reality check on that hit the markets hard, and when it does, the bulls are going to be in trouble.

You won’t be, though, because I’m going to prepare you for it and tell you exactly when to shift gears, take profits, and set yourselves up to make money on the downtrend. It’s as simple as looking out for one number on one index.

Let’s get into it.

How the Banking Crisis Plays Into the “Pivot” Narrative

We all saw what was hiding under plain sight when the banking grey swan’s spreading wings cast a shadow on the safety of American banks. What wasn’t being questioned, but should have been, was what happens to banks’ assets when rates rise from 0.0%-0.5% to 4.5%-5.0% (fed funds) in one year?

Losses happen, that’s what.

As rates rise, the prices of fixed-interest-rate assets (like Treasuries and agency mortgage-backed securities with considerably lower yields) fall. The value of trillions of dollars’ worth of fixed rate loans on banks’ balance sheets fall too.

At the same time, depositors have been exiting banks for much higher yielding money market funds.

The one-two punch, and constant jabbing and bruising of banks’ share prices, is impacting all banks and worrying analysts and economists the net effect will be a credit tightening cycle by banks at the same time economic growth appears to be slowing.

As I said, this is a big part of what’s driving the “pivot” narrative. And of course, investors know that markets perform spectacularly when the Fed’s lowering rates.

When the Fed pivoted the last four times on the heels of hiking regimes – in February 1995 after starting to raise rates in February 1994, in May 2000 after starting to hike in June 1999, in June 2006 after hiking in June 2004, and in December 2019 after starting a gradual hiking regime in 2015 – the average performance of the S&P 500 one month after pausing and cutting began was a gain of 3.3%; three months after cutting began the average gain was 8%; and one year later the average gain for the market across those 4 periods was 17.5%. That’s with a one year downturn of 14% in 2000.

So the historical picture looks rosy. But watch it: Houston, we have a problem.

Here’s Why the Fed Is Going to Stay the Course

The problem with that analysis and expectation is simply that there were no inflation concerns when the Fed started cutting rates over those four periods.

That’s obviously not the case today. For bullish bettors to be right, inflation has to come down, a lot.

CPI, even if it’s coming down from 9%, is still between two and a half to three times the 2% annual inflation level the Fed’s targeting.

With the Fed’s primary mandate being “price stability” and a 2% target it can’t possibly cut rates. Sure, they can and will pause. But whether that’s now or after one more 25 basis point hike doesn’t matter. Pausing is not cutting.

Another reason the Fed may not be inclined to cut, or even allude to cutting, is that just mentioning the possibility would be construed by worried investors that banks are in much worse condition than feared. If the Fed’s talking about cutting, they’ll think, then maybe the banking system is in danger of collapsing.

That’s why we’re not going to see rate cutting for at least another year. If we do see rate cuts, it will be because the market’s crashed and that will be too late for traders and investors.

“Higher for longer” is the path, and understanding what that means for stocks is critical to playing the market.

“Higher for longer” will further impair bank balance sheets, erode bank earnings and result in tighter credit conditions across the country. Yes, that will dampen demand, deepen any recession, and erode corporate earnings, all of which will necessitate a re-rating of stock market valuation metrics to the downside.

In the meantime, because we’re not there yet and traders are hard at work frontrunning an expected rate cutting cycle, stocks can go higher.

If they do, and the VIX drops down to an overly complacent 17 handle or 16, that’ll be your signal the head-fake rally is done, and it’s time to take profits and hunker down for a “back to reality” selloff.

When that happens, make sure to check back here so I can tell you how to play it.