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One of the big challenges of investing these days is to prevent missing the forest for the trees.

We’re now barraged with a lot daily market and economic info, at such a high decibel level, that it’s simple to miss broader cyclical modifications that happen over months and years.

But these modifications matter. So it’s worth going back from time to time and looking at the huge image.

I currently have a careful view of the stock exchange. I think stocks are very pricey, and, as a result, are most likely to provide lousy returns over the next 7-10 years. My view that stocks are expensive is supported by this chart from John Hussman, which shows 7 valuation measures that have actually been highly predictive over the past century. (The left-hand scale shows the forecasted 10-year return for stocks according to each evaluation measure. This return declares, a minimum of. But crappy.)

Chart of stock market valuation

Of course, as numerous of you’ve noted, observing that stocks are expensive informs you baby about exactly what stocks are going to do next – pricey markets can remain pricey. So it’s also valuable to think about what might trigger a pricey market to obtain less expensive (a.k.a., a ‘catalyst’).

I assume there are two possible drivers that might cause our present expensive market to obtain less expensive:

1) A decline in earnings margins from today’s record-high levels, and

2) A modification in the direction of Fed policy from relieving to tightening

On the earnings margin side, have a glance at this chart of earnings as a percent of the economy. Today’s earnings margins are the highest in history, by a mile. Note that, in every previous circumstances where profit margins have reached severe levels – high and low – they’ve consequently reverted to (or beyond) the mean:

profits as a percent of GDP

Now, you can tell yourself stories about why, this time, earnings margins have reached a ‘completely high plateau’ and will never ever once again revert to the lasting mean (6 % vs. today’s 11 %). And you may be right. However as you’re telling yourself these tales, please acknowledge that the story you’re really telling is called, ‘It’s different this time.’ And ‘it’s various this time’ has been described as ‘the 4 most pricey words in the English language.’

And then there’s Fed tightening.

For the last 5 years, the Fed has actually been frantically pumping money into Exchange, keeping interest rates low to encourage hedge funds and other investors to obtain and hypothesize. And this complimentary cash (and the resulting speculation) have assisted drive stocks up to their present very-expensive levels.

But now the Fed is beginning to ‘remove the punch bowl,’ as Commercial loves saying.

Specifically, the Fed is beginning to minimize the quantity of cash that it’s pumping into Exchange.

To be sure, for now, the Fed is still pumping oceans of cash into Exchange. But, in the past, it’s actually been the change in direction of Fed money-pumping that’s been important to the securities market, not the absolute level.

In the past, significant changes in direction of Fed money-pumping have commonly been followed by changes in direction of stock prices. Not always. However typically.

Let us go to the history…

Here’s a look at the last 50 years. Heaven line is the Fed Funds rate (a proxy for the level of Fed money-pumping.) The red line is the S&P 500. We will zoom in on specific periods in a minute, so don’t squint. Just note that Fed policy goes through ‘tightening’ and ‘easing’ phases, just as stocks go through bull and bearishness. And sometimes these stages are associated.

1966-2014

Now, we will focus. In numerous of these period, you’ll see that sustained Fed tightening has commonly been followed by a decline in stock rates. Again, not always, but often. You’ll likewise see that a lot of significant declines in stock rates over this period have actually been preceded by Fed tightening up. Once again, not all (the Crash of ’87 was a notable exception.) However the majority of.

Here’s the first period, 1964-1980. There were three big tightening phases throughout this duration (blue line)… and 3 big stock drops (red line). Excellent relationship!

1964 1980 stocks and interest rates

Now 1975-1982, which overlaps a bit with the chart above. The Fed began tightening up in 1976, at which point the market declined and then flattened for 4 years. Steeper tightening up cycles in 1979 and 1980 were also followed by rate drops.

1975 1982

Focusing in on 1978-1990, we see the 2 drawdowns described above, along with another tightening up cycle followed by flattening stock prices in the late 1980s. (Right here, we also see our first exception to the connection … the 1987 crash wasn’t preceded by (much) tightening! This is a good pointer that in some cases markets simply crash.)

1978 1990

And, lastly, 1990-2014. For those who wish to think that Fed tightening is irrelevant, there’s great news here: A sharp tightening cycle in the mid-1990s didn’t lead to a crash! Alas, two other tightening up cycles, one in 1999-2000 and the other from 2004-2007 were followed by major stock-market crashes.

1990 2014

One of the oldest phrases on Wall Street is ‘Do not combat the Fed.’ This saying has meaning in both directions, when the Fed is easing and when it’s tightening. An eye these graphes shows why.

On the positive side, the Fed’s tightening stages have actually frequently lasted a year or more before stock rates came to a head and started to drop. So even if you are persuaded that sustained Fed tightening now will likely cause a sharp stock-price pullback at some time, the bull market might still have a means to run.

But do not miss the forest for the trees!

SEE ALSO: Anyone Who Thinks Stocks Will Go Up If The Economy Grows Must Read This Buffett Quote

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