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We’ve certainly had a rip-roaring start to the year. The first question is, is that deserved?

What happened to create this great start? My belief is that two basic things happened to create the big January. First, markets got deeply oversold in December, and second, in January the Fed went from hawkish to sounding more dovish.

The oversold part is easy to address. Markets went down hard, bounced, and now they are getting close to overbought and hitting resistance levels. It’s fair to say that an oversold condition is no longer present as a positive factor.

The Fed seems to be the part that everyone is excited about. The Fed basically indicated it has stopped raising rates, at least for a while, and hinted that it may slow its QT (Quantitative Tightening – selling some of the securities it holds) plans. My question is, should we be excited? What’s happened in the past when the Fed took a more dovish stance?

Just to take recent history, in the 1980s and 1990s the Fed cut rates to fight unemployment and recession fears. In the 2000s, the Fed again cut rates to fight a recession and then kept cutting them to stimulate the economy.  What’s the pattern? The Fed doesn’t seem to cut rates in a time of peak profits and employment. The Fed becomes dovish when things are looking bad.

More importantly for our purposes, how did markets do in those times? Probably because unemployment, inflation, and GDP kept on improving, markets did quite well during easing in the 1980s and 1990s. Unfortunately, the 2000s period wasn’t so great. The market kept going down in the early 2000s despite the rate cuts.

So what can you really say about rates cuts? Not much, but I think it’s fair to say they’re not the driving factor for stock market gains.

You can say we’re not really talking about rate cuts anyway, at least not now. The market is excited about the possibility of less QT and perhaps a return to QE, or put differently, the size of the Fed balance sheet.

Unfortunately, the data on this is very limited, so it’s hard to say anything conclusive. While the period of QE from 2009 through 2018 by central banks worldwide was considered a positive for stocks, there were gaps, such as 2011 and 2015, which seemed to show maybe QE is just a short term patch for market performance, as any attempt to stop QE seemed to lead to trouble. The only other period of QE was a smaller plan in Japan in the early 2000s, which the Bank of Japan (BOJ) considered a failure and it didn’t help stock prices even with the BOJ buying stocks.

What do you do with all this uncertain experience? I’d say it’s not at all clear that the Fed and other central banks are the central determinant of stock prices. Thus, how excited should you really get about the thought that the Fed isn’t going to just keep raising rates, and may even slow the rate of change of their balance sheet shrinkage plan? Many investors are clearly excited, but does it make sense to follow them?

I always like to triangulate conclusions. Look at things from different angles and see if it still makes sense. I have the perhaps old-fashioned and quaint idea that earnings matter over time. Should we be concerned that earnings growth seems to have almost certainly peaked in the third quarter reports of last year? Should we be concerned that, according to Factset, year over year earnings estimates for the first quarter of this year are currently negative? And for all those managers gleefully buying tech, maybe they should note that the technology sector is showing the biggest decline in earnings?

There are four basic aspects I tend to look at in company earnings – sales, margins, asset efficiency, and cost of capital. Sales are slowing, margins appear to have peaked, asset efficiency appears unchanged, and the cost of capital has been going up. That last part is particularly interesting. There have been a lot of companies growing fast on the back of practically free capital. Is that party essentially over?

I suppose you can choose to believe that the Fed will ride to the rescue for stocks, but it’s unclear what path they’re going to take exactly, and it’s questionable how much effect it has anyway. In the meantime, I can see nothing else that tells me to aggressively buy stocks here, and plenty of reasons to be cautious.

Where does it make sense to invest in the stock market? I always like to hunt for what is unloved and avoid what is loved, and this time is no different. We’ve had a momentum-driven, low cost of capital market for quite a while. What mattered was growth at any price and momentum. I’d avoid that like the plague and take the opposite tack. In this new world where the cost of capital is going up, sales are slowing, and margins are shrinking, I’d look at companies that actually produce free cash flow. They can survive, and maybe even thrive in this new world.

You can always count on the market to change, and now sure looks like a place where we should expect change. The idea that the Fed can rescue the market isn’t strongly rooted in history, and the idea that any Fed accommodation should make you run out and buy tech stocks is particularly ahistorical. Investors were trying that same trick after 2000, and it sure didn’t work out well then. I see no reason why it could work out well now. Fed actions certainly can impact the market to some degree for some period of time, but the Fed is not omnipotent – even though people usually seem to think it is.