Cezary Salad

There’s an apocryphal tale about a nervous investor that’s made its way around Wall Street recently. The investor is nervous, the story goes, not because he sees turmoil in the markets but because he’s optimistic and doesn’t know whether his optimism is justified.

Sound familiar?

The month of May - colored with headlines like “As stocks rise, Wall Street turns optimistic,” and news such as the upward revision of Q1 2008 GDP growth from .6% to .9% - gave new strength to optimism that the worst of the credit crunch is now behind us, along with the expected backlash: what if it’s not?

It is against this backdrop that a newsworthy item published a few days ago by S&P Equity Research received little notice - perhaps dutifully so because these kinds of comparisons are all too common, but this one stood out for its optimistic tone:

“. . . the Standard & Poor’s 500-stock index advanced an average 19% during the 12 times since World War II after the Federal Reserve Board started a rate-cutting program. Indeed, the S&P 500 was higher 12 months after the first rate cut in 11 of the 12 observations, with 2001 being the only time in which the equity market benchmark was not higher a year after the initial cut.

This time around, even though the S&P is down 6.2% through May 16 since the Fed started its rate-cutting program on Sept. 18, 2007, the market was also still in negative territory six months after the first cut in four of the prior 12 observations, so we still have a chance for the “500″ to advance in the next four-and-a-half months.”

[FYI: a complete synopsis of market performance during post-WWII Fed easing cycles can be found here.]

The “glass is half-full” tone of this report may give investors confidence in light of the streak of positive news throughout last month, but I saw it much more as a warning of undue optimism in the market.

In February, looking at just the last four Fed easing cycles (2001, 1998, 1995, 1989), Bear Stearns estimated that, on average, the S&P 500 has gone up 5.7% and 7.6% during the first 6 and 12-month periods since the first rate cut, respectively. This time around, things look remarkably bleaker (see chart below):

Through the six-month period from the first Fed cut in September, the S&P was down a whopping 12.4% and - despite edging higher in the middle of May - now stands at about (8.00)% since the easing cycle started. That means that if the S&P is to break even for the 12-month benchmark since the Fed easing began, it will have to coast about 800 basis points higher in less than four months against the headwind of soaring oil and rising unemployment.

Possible? Sure. Highly unlikely? Definitely.

But the problem isn’t with the equity markets but rather with the economy’s fundamentals - which are the real benchmarks that investors should be paying close attention to. In the age of globalization, multi-national corporations and a weak dollar, U.S. equity indexes such as the S&P 500 just aren’t as good of indicators for the health of the economy as they used to be since it’s hard to tell whether they’re really reflecting domestic or international growth. But domestic unemployment - which recently jumped a steep .5% to 5.5% (up 1% year over year), rising inflation and soaring commodity price indexes continue to tell the real tale, and it should continue to make the optimistic investor plenty nervous about in the coming months.

[FYI: in case you are interested to see how the 10-year treasury yield has fared during the first half of the current Fed easing cycle, PIMCO provides a neat summary of that on their 2007 subprime timeline.]