The Fed has completely distorted the stock market - here's how its next few decisions could trigger the next meltdown

Paulo Whitaker/Reuters

• The Federal Reserve has underpinned stock market gains throughout the 9-1/2-year bull market by keeping lending conditions highly accommodative.
• Barry Bannister, the chief equity strategist at Stifel, sees this becoming problematic for stocks as the Fed adopts a tighter monetary policy.
• He lays out a scenario where future Fed rate hike decisions create the next big equity meltdown.

When it comes to the 9-1/2-year bull market, stock enthusiasts are quick to highlight the strong corporate profit growth that's led the way higher.

But what helped catalyze such impressive earnings expansion? Why, the Federal Reserve's historically easy monetary policy, of course.

That's the premise of Stifel's view that this has been a "policy bull market," built on the shoulders of the Fed's extremely accommodative lending conditions.

Sure, it's a cynical way to look at the longest bull run in history. But Stifel has a point. Back in 2008, when companies were going bankrupt in droves, the Fed stepped in to suppress bond yields of all types, in order to form a market backbone of sorts.

"US equities have become extensions of policy decisions rather than reflections of economic value," Barry Bannister, Stifel's chief equity strategist, wrote in a recent client note.

By this logic, Stifel believes that it will be the Fed that ultimately causes the next big market meltdown - undoing much of the progress it made following the financial crisis.

At the center of this forecast is a neutral Fed funds rate monitored by Stifel. The firm argues that, following two more rate hikes, this measure will cross a so-called "bear market trigger," which occurs on the rare occasions that the neutral reading climbs above the actual Fed funds rate.

As you can see in the chart below, this also happened in 2000 and 2007, right before large bear market sell-offs.

Stifel

"A 'maximum tolerable peak' for the Fed funds above the neutral rate has been associated with bear markets since the late-90s global debt boom," said Bannister. "The line connecting the tops has trended down, perhaps due to diminishing productivity of debt (ability of debt to generate GDP), which magnifies the rate sensitivity of borrowers."

In terms of how bad any stock sell-off can get, Stifel estimates that it could reach bear market territory. As for the timing of that 20% drop, Bannister says it could happen within the next six to 12 months.

But it doesn't end there. If that bear market does transpire, Bannister says it'll be followed by eight years of sideways trading for the S&P 500.

Before you go dismissing Bannister's grim forecast, consider that he was one of the Wall Street strategists that predicted the market correction that rocked stocks back in early February.

In terms of how traders can combat an imminent market crunch, Bannister recommends his "tight policy" trade. It involves going long defensive industries like utilities, REITs, and household products, while shorting areas like construction, energy, raw materials, and insurance.