Why Stock Investors Can’t Count on a Fed Rescue

In the past, the Federal Reserve had tried to stem steep declines in equity prices by cutting interest rates or by postponing planned rate hikes. Called either the "Fed put" or the "Greenspan put," after former Fed Chairman Alan Greenspan, investors should not expect such an intervention in the near future, The Wall Street Journal reports. The main reasons are, per the Journal, strength in the economy and stock market valuations that are excessive by many historic measures.

On February 8, the S&P 500 Index (SPX) dropped by 3.75%. Since reaching a record high at the close on January 26, the index has retreated by 10.16%, making this period officially a correction. Despite the recent decline, the S&P 500 is up by 12.48% during the past year, from its close on February 8, 2017.

The Journal cites recent research by academic economists who find that stock market returns are a more powerful predictor of changes in the Fed's interest rate policy than 38 other economic indicators, including employment, consumer spending and even inflation. Moreover, they indicate that attempts by the Fed to stem stock market declines are more common than actions to rein in stock market gains and deflate speculative bubbles. From their analysis of the minutes of Fed meetings, the authors deduce that falling stock prices may damage the economy, as consumers reduce spending in response to their decreased wealth, and as companies find it more difficult and expensive to raise capital.

With high stock market valuations, and growing concerns about asset bubbles, the Fed probably will take the stance that a deflation of equity prices would be a salutary event right now. The forward P/E ratio on the S&P 500 was 17.1 times projected EPS as of February 7, up significantly from values of around 10 in the recent low points for this metric in 2008 and 2011, per Yardeni Research Inc.

The CAPE ratio, a valuation measure developed by Nobel Laureate economist Robert Shiller of Yale University, was only higher prior to the Stock Market Crash of 1929 and during the Dotcom Bubble of the late 1990s. A contrary viewpoint holds that the deviation from trend is lower today than in 1929, that the upward trend in CAPE is justified by the maturation of the U.S. economy, and that today's low interest rates make a higher CAPE value economically rational. (For more, see also: Why The 1929 Stock Market Crash Could Happen In 2018.)

Key officials of the Federal Reserve System have shrugged off the recent decline of stock prices, and indicate that they will stick to their plan for interest rate increases in 2018. "I think it's healthy that there is some correction, a little more volatility in markets," is the opinion of Robert Kaplan, president of the Federal Reserve Bank of Dallas, as quoted in another Journal story. Also per the WSJ, William Dudley, president of the Federal Reserve Bank of New York, said, "My outlook hasn't changed because the stock market is a little bit lower than it was a few days ago. It's still up sharply from where it was a year ago."

The Journal indicates that the Fed expects stronger economic growth in 2018, leading to declining unemployment, and that the central bank is willing to let inflation rise to an annualized rate of 2%, which they view as a healthy level for the economy, by the end of 2019. Economists at Goldman Sachs are among those expecting four rate hikes by the Fed in 2018, and four more in 2019. (For more, see also: Why Stocks Won't Crash Like 1987: Goldman Sachs.)