Human beings are pattern-seekers. We are confronted by a world of disparate inputs, and we try to impose order so that we can operate amongst the distractions. Accurate pattern recognition leads to success, whether it be survival on the African savannah, or economic prosperity. However, none of us has the time to fully analyze all the data we see, so we develop heuristics (shortcuts, rules of thumb) to speed the process. The last few years have upended some of our most cherished economic beliefs.

Let’s examine some well-known failures to determine their cause.

The Federal Reserve began to raise interest rates in the Spring of 2022. The increase in the overnight rate from 0.08% to 5.40% rivaled the largest in absolute basis points and was easily the greatest in percentage terms. The United States essentially went from rates near zero to the highest levels this century.

In addition, the Fed started Quantitative Tightening, shrinking its balance sheet by a record amount. Of course, we all expected that this would cause a recession. This expectation was reinforced by the inverted yield curve which reflected the market’s judgment that the rise of short-term rates would result in an economic contraction, forcing the Fed to reverse course and lower rates. Over the entire post-war period, monetary tightening had caused recessions in 11 out of 14 cases (79%) and an inverted yield curve had an almost perfect correlation with subsequent recessions. The smart money said buy bonds, as they were destined to outperform stocks during the forecast economic downturn.

Didn’t turn out that way. 

The economy hardly missed a beat during the tightening cycle and continues to grow at a rate above potential. Something different is happening. That something different reflects the changed nature of the American economy. Service industries dominate traditional manufacturing in the United States. When the Fed raised rates, net interest payments by American companies fell. This was the result of huge cash balances at successful tech companies along with the previous prescient borrowing at low rates by all companies.

A similar situation occurred among households which had locked in low-rate mortgages and begun to earn some interest on their savings. A further fillip to the economy came from the huge increase in household wealth with both the stock market and home equity contributing.

We are now on the other side of the mountain. What happens when the Federal Reserve lowers interest rates? Heretofore, the path has been for stocks to falter while bonds rally. The idea is that the shift to easing is due to worries over the strength of the economy, and the Fed is typically late in spotting trouble. The quite weak employment report for August released a few weeks before the FOMC meeting in mid-September seemed to follow the script.

However, since then, the stock market has rocketed to new highs while bonds have fallen in price as their yield has risen. Once again, this correlation was upended by the ongoing resilience of the economy in the face of plenty of headwinds.

Now let’s turn to the stock market itself. A key observation has been that when the market is dominated by only a few stocks, the rally is on a weak foundation. Well, the concentration in the “Magnificent Seven” is at or near all-time highs. In response, the overall market is powering ahead to all-time highs. Another key human trait is that we use tools. The technological breakthrough of artificial intelligence has powered a good deal of the rally while recent quantum computing advances have added to the gains.

Why have we seen such a set of time-honored correlations fail?

There are two main reasons for what has happened. The first is related to our inclination to seek patterns. The fact of the matter is that the world is a far more chaotic place than our view of it. While the correlations cited have a good track record, they suffer from a small sample size. To get true statistical comfort, we need a lot more history, and we simply don’t have it. The second reason is even harder to admit, but it is closer to the truth. It may very well be the case that the world is different. The pandemic upended much of the world economy and reset many relationships.

Artificial intelligence and quantum computing are making huge strides. Perhaps the old rules just don’t work in the environment that now obtains.

Scary but full of opportunities for new rules.

Jamesson Associates is a financial advisory firm for community banks and thrifts based in Scottsville, New York.

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