How The Federal Pivot Could Shake Up The Stock Market: Are You Ready?

Erik: Thank you. Thanks for having me, Toby.

Toby: We’re going over the Federal pivot, the Fed pivot, what it is, and what tools they use to actually articulate these things to decide whether that’s going to happen. We’re going to define what a pivot is. We’re going to talk about the typical impact, what history teaches us, and then knowing what that impact will likely be, what you can do to hedge against it, so we’re going to dive right in.

My name is Toby Mathis, this is my YouTube channel and podcast. What we try to do is educate as much as humanly possible.

Erik Dodds here is a financial planner. He’s a fiduciary. He’s also a great trader who I’ve been working with for many years. We worked together on Infinity. It looks like you’re representing there. I can see it, infinityinvesting.com, which by the way, we will give you guys all a free membership to the basic membership. I’ll put a link in the show notes so you guys can all get there and you can also download the book Infinity Investing, absolutely free. We want to dive into this deep and heavy.

First off, let’s talk about, I’ll reverse the order a little bit, what is the Federal pivot and why is everybody talking about it?

Erik: What they’re talking about there is when we’ve been in a rate interest rate increasing environment and the call now is for the Federal Reserve to start cutting interest rates. They’ve been combating inflation. Now they feel like they’ve got inflation under control. People are saying, hey, you’ve got this under control. Why don’t you now maybe start cutting some interest rates? That’s the pivot. When they pivot from a hawkish rate environment where they’re raising rates into a dovish rate environment where they’re going to be reducing rates to try and maybe curtail any economic downturns.

Toby: When you hear people say, hey, we’re on a plateau, it just means that they’re not raising or lowering, right? We’re just sitting here. The Fed rate has not been moved up or down for quite some time now. I forget when the last time was.

Erik: July of 2023. It’s been a little over a year.

Toby: A little over a year. We’re flat. I’m just going to give you guys the date. Today is August 12th, just because things change constantly. It takes a couple of days to get this out. God knows what happens in the market. It’s been so volatile. What we’re trying to do though is give you the tools so you can make heads or tails of it.

We’ve been sitting here for the last year not doing anything, and now what’s the likelihood that we’re going to see a rate cut? I believe they meet in September and then December. What are the chances there? How are you calculating it?

Erik: I’ll share a couple of things out here. Let me do that real quick for you and that’ll answer that question. We’ll take a few months back too and maybe go into a little bit of history about where we’ve come from.

If you think of December of 2023, it’s just a little bit of last year, the Fed came out and at their meeting said really nothing’s going on. Then a couple of days later came out and talked about or gave the feeling at least that maybe there were some rate cuts on the horizon.

The market priced in, there were some rate cuts coming. You heard the talk at the beginning of the year, five, six, seven rate cuts, depending upon what economists were out there talking about it. Fast forward now to where we’re at right now, it’s August of 2024, there have been no rate cuts, so there has been no Fed pivot.

After last month and the meeting that the Fed had and the economic data that came in and jobless numbers came in, this is a Fed rate watch tool and you can see, so this is for September 18th for the meeting coming up there. This is where we’re at currently. The Fed funds rate being 5.25 to 5.50. This is where they’re projecting rates to be at coming out of the Fed meeting.

Right now, the Fed funds are targeting about 50% of it targeting a 25 basis point cut. That would be the pivot. That’s the first cut that we’ve had after this rate increasing cycle that we’ve been in. What’s interesting to note is that a month ago, it was about 90%. Where’d the rest of that go? The rest of that went to actually pricing in maybe even a bigger cut, a 50 basis point cut.

After the recent economic data, the market has priced in that we’re going to see pretty much a foregone conclusion, there is going to be a rate cut, it’s just a matter of how much. You do even have some economists, some financial pundits talking about in-between meeting cuts, in-between July and September, coming out with emergency rate cuts. That talk really got going last week when market volatility came in at the beginning of the week. On Monday, we saw the VIX spike to unprecedented numbers before intraday there.

It’ll be interesting to see how they handle it, and how the market reacts to it. It’s not like we haven’t been here before. The Fed has pivoted before from a rate increase into a rate decrease cycle. We have historical data on what the market does that doesn’t mean that it’s going to do the same thing. I think we’re going to talk about that a little bit, but I certainly want to give some tips on what people could do in anticipation of the pivot and the stock market reaction to that pivot.

Toby: Let’s back up real quick. You’re looking at the CME, you’re looking at a report of what the Fed believes. Who makes this prediction, by the way?

Erik: The FedWatch tool. This is effectively, you have traders that are pricing in what the Fed is going to do, and you can use this historically, you can look at November how things are priced in for November. You can look at how things are. There’s even some pricing in of lower cuts.

Toby: This could change tomorrow, right?

Erik: For sure and that’s the part that you can look at. You can see where it was priced in a month ago or a week ago and where it’s being priced in now. But what is being priced in is cuts by the end of the year, so we may get those five, six, seven rate cuts that were rejected. If this is right, we may get a lot of those cuts by the end of the year. It’s just not happening bit by bit by bit throughout the year. Right now the market’s pricing in from September to the end of the year cut.

Toby: Let’s back up just for a quick second and talk about why they’re doing this. Generally speaking, the Fed’s raising interest rates if they think it’s too much, the economy’s going too good. It’s like Talladega Nights, they got to go to Applebee’s. I’m getting a little shaky. Things are too good. Maybe we got to slow it down so let’s go get thrown at Applebee’s.

Instead what they do is they raise interest rates to make it a little more painful for folks to get access to money. They’ve been doing that for quite some time now. I’m talking about the increases, they were slowing us down until it sounds like July of last year. Now they’ve been watching to see what happens with the inflation rate.

Now we have inflation. It looks like it’s under control right around that 3%. They want to get it down to 2%, but it looks, at least according to, if you listen to the Fed and what they’ve been saying, it sounds like they’re satisfied that they think it’s going to be going in the right direction.

Then you get weakening job numbers. A lot of people, they seem to restate these darn job numbers all the time and that it might be softer than their reporting. But regardless, they’re saying hey, the economy suffered enough. Let’s not go into a full blown recession and how do we stop it from happening?

You try to soften that landing by lowering your interest rates, usually in 25 basis point increments. I don’t think they want to go 50 basis points, 75 basis points, or 100 basis points unless they were really feeling like oh no, something bad is happening, right?

Erik: Exactly and that’s the read on the market right now. If the economy isn’t all that bad and all things aren’t really broken, why would we be cutting 50 or 75 basis points? Why would I be looking for that?

The stock market may take that first cut, especially if it’s a deeper cut. The stock market may take that to say, whoa, something might be broken. Maybe we need to look at a potential sell-off in the overall stock market. That historically has, as we’ll talk about, been the case as well.

Toby: Let’s go to what the impact is. We know what a pivot is. Pivot is the first time they lower their interest rate. What does history tell us about that pivot and what’s important for people to understand?

Erik: It is from MarketWatch. It was actually earlier in the year. I think this article is from February of this year. But it talks about since 1974 what the market has done from when the Fed stops hiking to when the first cut is. We can assume that we see what the market’s doing now. We’ve got a month or so until the next meeting. Let’s assume the Fed is going to cut there. The market certainly could go up in the next 30-plus days.

Whatever the market’s going to do, most of that we feel is probably already in. Whatever it’s going to do between now and September. The question is what happens after the cut? You can share this article in your YouTube description if you want and all this information we’re using here.

When you look at the subsequent market low date from the cuts and the number of days from when they cut to the market low and then the percent change to the market low. They’ve got the different dates in here that you can look at as far as some those.

We can’t take COVID out because it happened, but if you look at the technical time period from when they hiked to when they cut, that wasn’t necessarily even in COVID, but it was August of 2019 before we heard anything about COVID. That’s in there.

One, for me, when I was pretty deep into my career, if you go back to the global financial crisis, the last hike was in June of 2006 and the first cut was in September of 2007, I believe. That bear market decline was about 55.5%. That was a pretty big down move.

The dot-com crash was a similar, about 40% down move, and you have some other ones where, again, the move after the first cut is a little bit more benign. Basically flat down half a percent, down 8%, down 1%, down 2.3%, and then in 1981, again, I wasn’t trading then, but down about 22%.

If you take all of those, the average of all those declines is about a 20% decline and the days from first cut to market bottom average is about 276 days. You have some that are very short. Most of them are pretty prolonged, lasting well over 400 days from first cut, which would be September to win the market bottom.

Toby: Let me show my screen real quick. I want to show you the graphic that’s been going around all over the place. Here’s the graphic that I keep seeing and it’s all the guys. It’s the usual suspects that the market’s crashing. A lot of red. A lot of down arrows and it’s catastrophic. It’s going to be horrible. There’s clickbait.

But the graphs are the graphs. The facts are the facts. When you have a Fed pivot, you do have these drawdowns in the last few of them, 35%, 58%, 51%. They’re not small. That’s going to freak me out. That’s going to freak grandma out if her account dropped half its value in a matter of nine months. It sounds like that’s about the average time. Is that what we should be expecting?

Erik: We can talk about what that is. We can talk about what that number is, where that puts us based upon today. Obviously we don’t know, but we can use past numbers to predict what might happen. Here’s a chart of the S&P 500. I’m using SPX here.

What I did was I just charted out where we’re at today. On the monthly close, where we closed today and a 20% down move 20.5%, if you want to use that average number would have us down about 40%, 42.51%, 42.50% in the S&P 500. If you’re trading something like SPY, which is the S&P 500 ETF proxy, that’d be about 4.25%. 55.5% move would have you down to about 23.78% in the S&P 500.

Those are both pretty scary numbers. It’ll be interesting to see how the market reacts this time. The last time we saw this, obviously we got a lot of money in the COVID era. That’s really the last time we saw those quick emergency cuts and that was hopefully a unique situation.

We’ll see where this ends up being, how fast the recovery may be. Is it an average time? Is it beyond average time? We don’t know, but enough of that wall of worry stuff. There are other indicators that we look at, which we say recession is here or very close, oftentimes the NBER (National Bureau of Economic Research) will go and it’ll be backdated.

We see the indicators now. They’ll go back and say we were in a recession starting in May or starting in June or whatever it was in 2024. You don’t really want to wait until that headline hits because it’s probably already too late. What can you do to clean up your portfolio maybe now as it may be.

I think what you need to do is break yourself down into whether you are an investor or whether you are a trader. I think if you are trader, if you’ve been doing S&E for a little bit of a while, and you’re actively involved in the market, you’ve hopefully got your game plan down.

What you’re probably looking for is ways that you can profit when the market goes down. Maybe you’re doing short stock ideas, which again, a lot of these things can have lots of risks to the upside. You have to be aware of that. I’m just throwing ideas that are certainly risky but ways that you can profit on that.

Another way you can do it would be by investing in puts. By buying a put option on the market that gives you the right to sell shares at a higher price. Those would see an increase in value, assuming that the market fell in the time of your contract, if your portfolio was down.

That’s a way that professional institutional managers, as well as retail traders, will look to hedge the portfolios by buying options that profit when the market goes down.

That’s if you’re a trader, I think a lot of people that we work with may also, they may be traders, but they also may be investors. If you’re a long-term investor maybe because of capital gains reasons, you have a good tax firm in Anderson that you could go to if you have capital gains issues, but let’s say that you don’t want to sell out of something because the taxable gains are going to be too much.

I think if you’re a long-term investor in stocks and in the indices, if you want to hold the positions through what could be a market downturn, and there will be stocks that outperform, but if you want it to, you could sell a covered call against your position. Now, that’s not going to protect the entirety of the position, but it will generate some cash flow and it will help soften the downside a little bit. That’s one thing that we talk about.

Normally in our classes, we talk about using an option Delta, which I won’t go too far down that path now, but basically we use the percentage probability that the option will expire worthless or in the money. Instead of using maybe a lower Delta option, maybe you can increase the Delta, be a little bit more aggressive on your strike selection to generate more income to maybe protect that downside. Again, you’re going to limit your upside if you do that, but that’s one thing that you could do.

Then one other thing you could do and then I’ll give you back the floor, Toby, is you could use some of that call option income and buy a protective put on that stock that you own.

You could do what’s called a caller strategy where instead of just outright buying the insurance of the protective put, you sell a call option to generate income. Then you can decide at that point if the market or your stock does go down, whether or not you want to sell it or take profits on the put and then keep your stock at a depreciated value. I’ll stop right there so you can jump in on that.

Toby: I want to say an option is selling some of the ability to pay more for your company or for your stock at some point in the future. We’re at a set price. It doesn’t have to be more than what you paid for technically. Let’s just say you sold out of the money option to somebody. That means that, hey, I bought it for $50. They can buy it for me for $55 at some point in the future. You make a little bit of money for that. Somebody is willing to give you a little bit of money for that. Depending on the company, the volatility, there’s a market for it.

On the same side, I could sell somebody or I could buy the right to make somebody pay for my company. I could buy a put which gives me the right to put the stock to somebody at an agreed upon price.

Erik: Yup.

Toby: If I bought it at $50 and I’m afraid it’s going to go down to $40 or that it’s going to take a major hit, that’d be a 20% decline and I’m really worried about that, I could buy a put at that $50 mark to force someone to buy it from me at $50. The only thing I’m out is the cost of that premium to do it. It’s like insurance.

You’re saying using a combination, you sell the option so you’re selling the call option so you can buy the put option and collared the stock. If it goes up, you’re probably going to get called out and whatever you paid for the put, maybe depending on if it expires worthless, if the stock goes way up and you’re not going to get that. If it goes down, you’re going to get paid and you get to keep the call option. I could see how that would make sense.

By the way, if this gets confusing for anybody, again I’m offering you guys a free basic membership. Just go to the link in the show notes. There’s Infinity Investing and it’s absolutely free. There’s never a cost when you’re doing the basic stuff so you can learn some of these things.

Also, Erik does workshops periodically that you could attend and learn more. Also, you can get a free copy of Infinity Investing where you can learn how to be a stock market landlord. There’s a bunch of this stuff in there in the later chapters so you can learn how this stuff works.

All right, first up. Thank you, Erik, for that explanation.

Erik: For sure.

Toby: That sets the table. Now, I’m going to finish with who this really impacts. If you could, let me borrow the screen again. Who does this really impact? I just did the total share of net worth held by the top 1%. This is the FRED (Federal Reserve Economic Data) and you could see that right around now, just over 30% is held by the top 1%.

Who is this really hurting? Well, if about a third of it’s owned by the rich people, then it’s hurting the rich people in these things. Then here’s the 90th to 99th and there’s another 36. Just adding those two up, we could pretty much figure out that 66.6% of the market of the assets are held by the top 10% of people. Then just to put an explanation point on this, here’s the bottom 50% of total net worth. It’s about 2.5%.

Realistically, the people that are going to get hit by this are going to be the wealthy and the people that are invested in the market. Now, what should you do? I’ll ask you that, Erik. What would you tell somebody who’s an investor and they’re holding on long-term. They’re planning on retiring off their money. What would you tell them knowing that there’s going to be some volatility and there’s a likelihood as a broad market drawdown?

Erik: Again, I think it goes back to what we talked about. I think that you’ve got to look to protect the portfolio. You have to be willing right now to maybe give up some of the upside. The market’s had a really nice run.

Now, that doesn’t mean that it can’t keep going. The market can go up as high as it wants to, as far as it wants to, and sometimes it can be during a time period that may not even make sense for it to keep going up.

Conversely, on the downside, if you’re worried about an economic downturn, there are some simple strategies out there that you can do, like we discussed, to protect your portfolio.

Toby: I’m just going to pull this up so they can see that the market continues to go up every single time.

Erik: It does.

Toby: Even if you had sat there and you just winged it.

Erik: Exactly. In 2007, I think it wasn’t until about 2012 or 2013, somewhere in there, you got back to that level that you were at. If you are living off of your money right now and you’re heavily invested in the market and you’re using your stocks to live off of, then I think you have to think about really protecting that.

If you’re 20 or 30 years old and you have a lot of years ahead of you to invest, maybe you can stomach that or again, maybe you look at some strategies that allow you to profit in the downturn. Then you look to start when you get to what you think is a market bottom, then maybe you look to buy the dip as it may be.

I think you just have to plan accordingly with where you’re at in life, but there are strategies that you can do that are simple to employ that can protect your portfolio. Maybe not everyone talks about it or maybe not everyone helps educate on it for whatever reason. There are ways that you can do it and that’s what we’re here to do and help with.

Toby: I would just add this. You continue to buy regardless of the market condition. I should say it’s almost impossible to predict what’s going to happen in the market. It goes all over the place, goes up, down, sideways. I’ll use an example. I think two of the biggest days in the market’s history were during the depression and during 2008. You miss it if you’re not in the market. You miss those upswings and it can be a very painful lesson.

If you start selling off everything thinking, oh, I’ll buy when the market corrects, you’re going to miss the market correction statistically, and over time, many many studies, I saw one where they did 70 some back tests trying to time the market, even if you were perfect compared if you bought it at the bottom every time, you weren’t that much better off than had you just continued to buy consistently throughout. Why does that work? Because you’re buying into the bottom. You just don’t know where the bottom is.

If you’re buying consistently over time, you’re going to get that benefit anyway. I would say you just hold tight. Yes, you could still hedge. Yes, you could do the puts. Yes, you could do a market put. There are probably funds that are based off of the market crashing. I imagine there are ETFs. Otherwise, you just got to put on the SPY.

Erik: Yeah, but that’s the other thing you could do. If you have a heavy tech portfolio or a heavy dividend portfolio, you could look and instead of just buying a put on all those stocks, you could buy a commensurate number of puts in the S&P, in the index itself, and that’s probably a less expensive way to do things as well.

Obviously, you may not want to sell the call against that if you don’t own shares of something, because that would be a naked call and that’s more a different topic of conversation, but buying the puts your only risk is what you pay for the puts. It could go to zero, the puts that you buy, but they could also help protect your portfolio. It’s a limited risk strategy, which is nice with that.

Toby: And like with all things, again, the market’s fluctuating all over the place. I’ll pull up one graph just cause I like messing around with graphs too. This is just an overlay of the SPY and the target Fed rate where you can see where they drop it. Hey, it’s going down and you can see the market. Oh, it’s going down and then it sits down here forever.

The market’s coming back up. They start raising it up. There goes the market comes back down a little bit and then now they’re lowering the interest rate again and looking at the market. It didn’t like going straight down. It popped back up. Then that’s probably COVID right there having an influence and then it just continued marching on its way up.

Overall, the market’s always gone up. If you hold, you’re going to be fine. If you take some proactive measures to try to minimize the hit, if you expect it to come, which again, it seems like every time they lower interest rate, it’s because the economy is showing some sign of weakening, which you always say, which is causing it.

I think it’s when they start lowering the interest rate is because they’re resigned to the fact that, yeah, we’ve damaged the economy enough. We’ve slowed it down now. We just don’t want it to go into a complete recession. But everybody now knows that the economy has slowed down. It’s like you tripped them.

They’re doing a slow motion crash. They’re going to get back up and they’re going to run again, but they crash for a little while. Skin their knee, get back up, brush it off, and then take off again.

The Fed made sure they tripped them. That’s all they wanted to do. Let’s trip that economy so we don’t have runaway inflation.

Erik: Little speed bump along the way.

Toby: I just have bad analogies. That’s exactly what it is. They put a speed bump up and what it did is it knocked your bumper off like you have an old 70s Pinto and the bumper fell off.

Erik: Oh man.

Toby: The Feds are like I didn’t mean to do that. It’s like yeah, you did. There’s a speed bump on it. We know what they did and they know what they did and it’s working as intended and they’re going to slow down a little bit of the inflation CPI. We’re going to see, hopefully, they’ve done their job and they knock it off for a little while. If you see a 50 basis point cut though, my fear is that you just signaled to the market that they cut a little deep.

Erik: Right, I 100% agree. If it’s too deep, too fast, multiple cuts, I think that could be a signal to the stock market that something is broken. Because why are you going to cut that? Just not that long ago, they were saying how great the economy was, and again there have been some recessionary signals that have already started to trigger here.

The rate of unemployment increase from the bottom has been steadily rising. Those things, if the economy is so great, why are you cutting so fast is one way to certainly look at it. The market will read into that in all likelihood and then we’ll see. But we still got a few months as of filming this until the Presidential elections so we’ll see if things stay stable until then.

Then who knows how it’s going to play out, but we just have to be aware. These are all just things that we’re aware of and then we can make some educated decisions on our portfolio, at least by hanging around people who do this for a living.

Toby: You got it. All right. Appreciate it, Erik. Again, if you can like, subscribe, and share this with anybody you think would benefit from the data, and I’ll put in a free link to Infinity Investing portal. You get the basics.

You could actually download the book and you can read and learn some of these concepts so that you too can be prepared for when that Fed pivot occurs, which appears to be eminent, whether it’s depending on who you believe could be as soon as September, probably December at the latest, but you’re going to see it. It’s just a matter of time now. We’ll go from there. Thank you, sir.

Erik: Thank you, appreciate you.