Sell in May and go away…

Ah yes, the familiar adage among investors that comes up this time every year. It refers to the calendar tendency for below-average stock market returns from May to October.

But this time around, what really matters is “sell Jay and go away.” Federal Reserve Chairman Jerome Powell, that is.

Today marks the conclusion of a pivotal meeting among Fed officials (I would note that I’m writing this before that meeting concludes).

You can expect a half-percentage point rate hike, plus additional details regarding future rate increases and unwinding of the Fed’s massive $8.9 trillion balance sheet.

But based on what many officials have said during the run-up to today’s meeting, it’s just the beginning of a tightening cycle that’s already wreaked havoc on the stock market.

Which is why you should still be concerned about what lies ahead for your portfolio.

A New Reality

Markets all over the world are quickly adjusting to a new reality. The interest rate on the 10-year Treasury has doubled to 3% since the start of the year. Even so, yield curves are moving toward inverting, which historically has been a dependable recession signal.

All that has sent the S&P 500 downward over 13% through the end of April … its worst start since 1939. Only a few asset classes have been spared from the volatility so far this year, as you can see below.

2022 YTD%

But despite all the drama, today is only the second time that the Fed has hiked rates during this cycle, which means they still have a long way to go.

That’s because the Fed is way behind the curve in taming price pressures like never before. You can see proof of this in this chart of the Fed funds rate versus realized inflation:

Fed Rate vs realized inflation

The Fed is just coming up shorter than any other time in history … showing how far interest rates must come up to catch inflation. Here’s why that is important, and what it means for the stock market looking ahead.

Fast Versus Slow

In the past, the pace of Fed hikes has played a major factor in future stock market returns.

The chart below shows how the S&P 500 has performed during past rate hike cycles and one pattern becomes clear.

Fed guiding toward a fast tightening cycle

Source: Ned Davis Research

When the Fed hikes rates slowly over time, performance tends to follow the black line. The market will continue delivering gains even after the first rate hike (in that case). But if the Fed moves faster to hike rates, then the results typically track the orange line — with poorer returns and higher volatility.

Why does the market respond so poorly to swift actions by the Fed?

There are several reasons.

Rate hikes dampen economic activity which eats into corporate profits. Higher rates also give investors the incentive to pull money away from stocks and allocate to bonds as their return becomes more attractive.

Either way, the message I expect to hear from Powell today is that the Fed intends to rapidly close the gap between short-term interest rates and inflation … plus details to shrink the $8.9 trillion balance sheet.

That means more uncertainty for investors ahead and why this May could be the perfect time to sell Jay and go away.

Best regards,

Clint Lee
Research Analyst, The Bauman Letter