“Don’t fight the Fed” is an important rule for investors. Here’s what that rule means.
In the long term, both individual stocks and the overall stock market performance aligns with their earnings potential. If the earnings potential of an individual company drops, then that company’s stock prices should fall in a commensurate way. That makes sense because a stock is essentially a claim on a company’s future earnings.
The Federal Reserve creates monetary policy for the United States. They have the ability to control security prices directly and indirectly – for both bonds and stocks. Now, if a single company is having a problem, the Federal Reserve is unlikely to get involved. However, if the overall markets are getting pummeled (say, by a financial crisis spurred by the coronavirus outbreak), the Federal Reserve might decide to intervene with interest rate cuts and direct asset purchases – injecting liquidity into a strained market and acting as a backstop on valuations.
A pessimistic investor might look at the loss in earnings potential and think the markets should fall broadly. A chastened, realistic investor might look at the widespread loss in earnings and believe in a recovery, fueled by the actions of the Federal Reserve. That’s what “Don’t fight the Fed” means. The Federal Reserve yields a tremendous amount of influence through their policies.
Of course, there is no such thing as a free lunch. The Federal Reserve cannot provide limitless and infinite support for all times without consequences. At worst, an overextended Federal Reserve might create credibility problems for the overarching market systems that modern economies depend on. More commonly, a policy of unlimited monetary support can create asset bubbles that simply defer inevitable fall to a point in the future. (Critics believe the housing bubble of the mid 2000’s was inflated by overly lax Fed policies in the 1990s.) Instead of a slow managed decline, asset bubbles can collapse swiftly and much more painfully. Federal Reserve actions can also change who bears the burden for their policy. For instance, current actions taken the by Fed are punishing to savers, who must deal with the dual challenge of lower interest rates (which means less income for them) AND the inevitable inflationary problems caused by infinite potential funds chasing ever fewer real-world economic goods, services, and securities.