The pause that doesn't refresh
'An end to rate hikes is near!' has been bulls' rallying cry for months. Only thing is, it shouldn't be.
By Alexandra Twin, senior writer

NEW YORK ( -- Stock market pessimists looking for further evidence that a selloff is looming just hit the jackpot: The Fed decided to pause.

After 17 straight rate hikes that took a key short-term lending rate from 1 percent to 5.25 percent, the central bank decided Tuesday to hold rates steady for the first time in more than two years.

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Whether that was a good idea is up for debate. Whether the Fed ends up needing to raise rates again in the months ahead is unclear. The central bank's policy-makers left the door open, just in case.

What is clear is that regardless, the pause is not likely to help stocks.

Since 1929, the Standard & Poor's 500 index has averaged declines of 2.5 to 4 percent in the three months, six months and 12 months after the end of a rate hiking cycle, according to Ned Davis Research.

That's because more often than not, when the Fed's through raising rates, that has coincided with a slowdown in the economy, which is usually what the central bank was after in the first place - and in some cases, the start of a steep downturn for stocks.

"Tightening cycles don't have to bring in bear markets, but they tend to make them more likely," said Ed Clissold, senior global analyst at Ned Davis Research.

Since 1974, bull markets, as measured by the S&P 500, have typically topped out about two months before the Fed is done tightening monetary policy, said Jeffrey Hirsch, editor at Stock Trader's Almanac.

So with the current bull market more than 3-1/2 years old, and perhaps having peaked in May, things aren't looking so good.

Need further evidence to suggest that a pause is unlikely to translate to stock gains? This is Fed chief Ben Bernanke's first year at bat, and that makes him vulnerable to what might be dubbed "the new guy effect."

Three of the last four Fed chairman - Arthur Burns, Paul Volcker and Alan Greenspan - saw stocks slump to bear market lows within the first year of taking the helm at the Fed, Hirsch said.

The one exception was William Miller, who chaired between Burns and Volcker. How did he manage to escape the new guy effect? Good timing. Miller started his term a few weeks after stocks hit a low for that bear market in February 1978, Hirsch said.

How's that? Paws or pause?

Rising interest rates slow the flow of money through the economy, denting growth and eventually eating into corporate profits, ultimately making stocks more expensive relative to earnings. That's why stock investors dislike rising rates and would prefer the Fed to end its current hiking cycle sooner rather than later.

But investors also want to know that the Fed is keeping inflation in check, especially now when a global economic expansion and geopolitical pressures are driving energy prices to record highs. There's been upward pressure on labor costs in recent months as well.

In trying to fight inflation, there's always the risk that the Fed overshoots and doesn't just slow growth but sparks a recession. The job is always tricky, since it takes six to 12 months for the effects of rate hikes to be felt, but especially now, with so many cross-currents affecting oil prices, inflation and the U.S. economy.

Whether the Fed can achieve a so-called soft landing - slower growth and lower inflation with no recession - is what investors have been worrying about lately. The slowdown is coming - GDP, the broadest measure of the economy, slowed markedly in the second quarter, and job growth has been weak for four straight months.

"I think the Fed is between a rock and a hard place," said Stephen Leeb, president at Leeb Capital Management. "You can't simultaneously promote growth and fight inflation, not with oil prices over $70 a barrel."

Investors are hoping that if the Fed stops raising now that will lead to a soft landing, and a positive atmosphere for stocks.

But the Fed's track record on this issue isn't so great. Take the three-year bear market that followed the end of the 1990s boom and the events of Sept. 11th. (For more examples, see the chart).

"The last time the Fed successfully engineered a soft landing was '94, but the circumstances were very different then," said Stock Trader's Hirsch. "Oil was at five-year lows, housing had bottomed and we were at the outset of an incredible technology boom," Hirsch said.

Also back then, the economy was growing on average at a 3 to 3.5 percent rate, yet inflation remained contained, said Leeb. But now the economy's slowed to a 2.5 percent growth rate in the second quarter, and inflation is higher.

There are additional headwinds now, according to Ram Kolluri, chief investment officer at GlobalValue Investors, notably the likelihood of slower earnings growth over the next 12 months and the impact of the slowing housing market.

The inflation equation

But perhaps the bigger problem for stock investors in the months ahead is that although the Fed has paused, there's little to suggest inflationary pressures will wane, barring an economic slowdown, analysts said.

"Inflation is real," Kolluri said. "Global expansion and demand for commodities is robust and it's not going to slow in the short term."

The upside is that the rise in global demand has helped the U.S. economy and will perhaps temper the coming slowdown, Kolluri said. The downside is clearly the upward pressures on inflation.

What's worse for investors is that the Fed's hands may be tied to some extent, according to Leeb, because the strength of global demand means even the Fed may have a hard time curbing inflation.

The only way the Fed could have a big impact on inflation, he said, is if they threw the economy into recession. Why? In such an environment, demand for commodities would drop as would the price of oil. But the tradeoff would be disastrous for the economy and by default, lousy for stocks.

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