stock market, S&P 500
The stock market surged in response to Fed rate cut signalling, but there is ample evidence that this S&P 500 rally could implode in a blaze of glory. | Source: Shutterstock

By CCN: The stock market has officially exited its mid-year slump. The Dow Jones surged more than 500 points on Tuesday. It added more than 200 points to the tally today. The S&P 500, meanwhile, has climbed nearly four percent from its recent low.

This massive reversal in sentiment came about as the Fed has reversed course and now looks set to cut interest rates. But that’s hardly an all-clear sign for the stock market.

Past Rate Cuts Often Preceded Market Wipeouts

s&p 500, stock market rally
The S&P 500 and other key stock indices have roared back to life this week. Enjoy it while it lasts. | Source: Yahoo Finance

Rate cuts have a mixed track record of predicting stock market swings. Bulls can point to several reductions in the 1980s and 1990s that led to extended bull market romps. In 1998, for example, the Fed slashed rates, leading to an epic bubble in tech stocks over the next 18 months. Of course, we know how that ended.

More recently, the tide has turned. January 2001’s first rate cut was followed by a recession and a collapse in tech stocks. In 2007, the Fed first cut rates during the summer as the housing market slumped. The stock market peaked in October and proceeded to utterly collapse over the next year. Anyone that bought stocks in 2001 or 2007 because of the rate cuts got crushed.

As strategist John Hussman put it: “You’re gonna wanna cool those jets” about rate cuts necessarily being a plus for the stock market. He posted a chart showing the dramatic connection between rate cuts and stock market crashes over the past two economic cycles:

Rate Cuts Signal Big Problems for Stock Market

It’s important to remember why the Fed cuts rates. The Fed does so when it is scared that the economy is about to break down. Mark Yusko, the outspoken head of Morgan Creek Capital – and, as an aside, a huge bitcoin bull – laid out the contrary view on a potential rate cut. He said:

“Rate cuts are a sign of economic weakness, not strength. Economic weakness makes high equality valuations more dangerous.”

If the Fed was confident that the economy was still prospering, it wouldn’t be considering rate cuts. And as Yusko notes, near record high stock prices make the risk to investors even more severe when a recession hits. He concluded by saying “risk happens fast.” That’s something many newer investors won’t realize until it’s too late.

No Guarantee Fed Will Cut Rates

The market is now predicting better than even odds of three rate cuts in 2019. That’s right: three.

That’s a crazy swing. As recently as February, the Fed was still considering additional rate hikes this year. That means there is a big chance that the market is overreacting.

Sure, the trade war has crushed sentiment and caused a slowdown in specific key sectors. But unemployment remains near record lows, consumer confidence is high, and GDP growth remains solidly in positive territory.

The Fed has a mandate to balance unemployment and inflation. With unemployment in such good shape and inflation near the target, there’s no need for the Fed to take drastic measures. You can see this in one chart:

The Fed may elect to give into investor sentiment and cut rates anyway. But don’t bank on it.

If they don’t give the market the cut, expect this 700 point Dow rally to get wiped out. Even if they do cut rates, keep in mind that it’s hardly a bullish indicator for the stock market.

In short: this silly rate cut rally could easily end in an S&P 500 implosion.

This article was edited by Josiah Wilmoth.

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