As has been the case for quite some time, worst-case economic and market scenarios
dominate the headlines. If the stock market drops, it will continue to do so. If it rises, the decline will resume soon. But the stock market has almost doubled since 2002 despite the headlines because the fundamentals have been and remain favorable
Recession risk matters to investors because bear-market declines in the stock market have tended to start before broad and deep economic declines have taken hold. The fundamental cause behind past recessions has been restrictive Federal Reserve policies. And real interest rate levels have provided the best clues about the extent to which the Fed’s policies were restrictive or not.
The Fed’s policies were restrictive in the past when the real or inflation-adjusted federal funds interest rate rose above 450 basis points. Until and unless the real fed funds rate rose above that level, no recession occurred and Real GDP (Gross Domestic Product) expanded faster than its historical trend.
The causes behind bear markets in common stocks have been restrictive Federal Reserve policies and/or extreme market overvaluation relative to interest rates. Until and unless the real fed funds rose above 450 basis points and/or the stock market became overvalued in the extreme, corrections occurred but no bear market erupted.
The real federal funds interest rate is now around 325 basis points – well below the 450 basis points that preceded recessions and bear markets in the past. And the stock market remains undervalued relative to interest rates – not overvalued in the extreme like it was around past market peaks.
Since real interest rates and the stock market’s relative valuation are nowhere near their “tipping point” levels, it follows that recession and bear market risk have been and remain low. The economic expansion should reaccelerate and that the stock market should rise on balance in the months and quarters ahead.
The recent rise in long-term interest rates does reflect a new awareness that the economic expansion has remained robust outside the housing sector. Concern has now shifted from the notion that the weakness in housing would result in recession to the fear that the rise in long-term rates could do the job.
But the sharp rise in long-term rates has left them below the federal funds rate – which in turn is still well below threatening levels. And there is no special reason to expect the Federal Reserve to raise rates soon.
Investors should not let the headlines distract them from these favorable fundamentals.
