What Edson Gould Would Say About Stocks, If He Were Alive

John Dorfman

June 28, 2021 — (Maple Hill Syndicate) – People who are fretting about the Federal Reserve’s latest comments probably never heard of Edson Gould.

Gould, a famed stock analyst from the 1940s into the 1970s, tried to devise an answer to investors’ perennial question: When should you take defensive measures if the Fed is tightening credit conditions?

He called his guideline “Three steps and a stumble.” It states that the time to get cautious is when the Fed has raised interest rates three times.

Today, the Fed hasn’t raised interest rates at all. It has merely said that it may do so as soon as 2023, rather than 2024, as it projected earlier. So under Gould’s guideline, we have not yet seen even one “step.”

In Gould’s day, the Fed often adjusted short-term interest rates by half a percentage point at a time. In recent years, the Fed has tended more to deal in quarter-point moves.

So, in my opinion, it might take more than three rate hikes to halt the ongoing bull market, which began in March 2020 while the pandemic was still raging.

Why Rates Matter

Low interest rates fertilize stock gains in three ways.

  • Businesses find it easier to borrow and expand.
  • Investors aren’t drawn to bond and other fixed-income vehicles, making stocks relatively more attractive.
  • Rates also affect the formulas analysts use to calculate the value of a stock. If you think Amazon will earn profits of $100 a share in 2025, what does that make the stock worth today? If rates are lower, the answer is higher.

Conversely, high rates slow business expansion, make bonds more attractive relative to stocks, and lessen the present value of a future stream of earnings.

So it’s no wonder that investors watch the Fed the way Kremlinologists used to watch Moscow.

What the Fed Said

The Fed had been dovish for so long that the slightest hint of hawkishness sent traders into a tizzy.

On June 17, the Fed released the “dot plot” it issues after each Fed meeting. The dots show where various members of the Fed’s Open Market’s Committee think interest rates will be at time points in the future.

The next day, James Bullard, president of the St. Louis branch of the Fed, hinted that further steps toward tightening monetary policy might be needed, given that inflation is rising faster than expected.

These things fall into the realm of what used to be called “jawboning.” Talking about possible policy changes can affect the market – and did, for a couple of days.

But the market’s climb resumed the week of June 21. In my view it would take concrete policy actions, not merely jawboning, to reverse the market’s direction.

How Good is the Rule?

If it’s true, Gould’s rule is manifestly useful. It can help keep investors in the market to enjoy the last, “blow-off” stage of a bull market, yet get them out before a significant decline.

But how accurate is Gould’s guideline? A study by Ned Davis Research Inc. suggests that it is generally a good warning system. The firm identified 16 sell signals from the Three Steps and a Stumble rule. In 14 cases, the Dow Jones Industrial Average declined.

The median decline was 17% and the median duration of the downturns was 414 days. (The mean, or average, was a decline of 12%, lasting 465 days.)

False warnings were given in 1989 and 1994. So the way I see it, the warnings were right about 88% of the time.

However, there have been some significant market declines for which the Three Steps and a Stumble rule was never triggered. That would include the crash of 1987, the housing-crisis bear market of 2008, and the coronavirus bear market of 2020.

In short, exogenous events having nothing to do with Federal Reserve policy can trigger a bear market. But if it’s Fed policy you’re worried about, I believe that Edson Gould’s guideline is a pretty good one.

One potential fly in the ointment is that today the Fed affects the economy by the bonds it buys (or doesn’t buy, or at some point sells). So interest-rate adjustments aren’t the whole picture any more.

I think the Fed will reduce its bond-buying activity as soon as next year. But I don’t think that it will immediately bring the current market rally to a screeching halt.

The stock market can decline even when the economy is booming. But in my view it is unlikely to decline in the early stages of a genuine boom – which is where I think we are now.

John Dorfman is chairman of Dorfman Value Investments LLC in Boston, Massachusetts, and a syndicated columnist. His firm or clients may own or trade securities discussed in this column. He can be reached at jdorfman@dorfmanvalue.com.

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