The Federal Reserve is charged with maintaining stable prices and maximum employment. Adjusting the target range on the federal funds rate is one tool policymakers use to accomplish that goal. The federal funds rate is a benchmark that impacts other interest rates across the economy. Higher rates discourage borrowing and slow the economy, and lower rates do the opposite.
In 2022, the Fed began an aggressive rate-hiking cycle to curb the runaway inflation triggered indirectly by the pandemic. Policymakers ultimately pushed the benchmark rate to its highest level in two decades. However, they reversed their stance in September 2024 in response to cooling inflation and a softening labor market.
The Fed announced a half-percentage-point rate cut on Sept. 18, marking the first cut since 2020. The S&P 500 (SNPINDEX: ^GSPC) has already jumped about 2% on the news, but history says the stock market could move much higher over the next year.
The S&P 500 tends to produce positive returns when cutting cycles begin
Since 1984, the Federal Reserve has guided the economy through 11 rate-cutting cycles. The table shows how the S&P 500 performed during the 12-month period following the initial reduction in the federal funds rate in each cycle. Importantly, the index produced a positive one-year return nine out of 11 times.
|
First Rate Cut |
S&P 500 Return (12 Months Later) |
|---|---|
|
October 1984 |
13% |
|
March 1985 |
32% |
|
December 1985 |
18% |
|
July 1986 |
27% |
|
November 1987 |
11% |
|
June 1989 |
14% |
|
July 1995 |
19% |
|
September 1998 |
21% |
|
January 2001 |
(14%) |
|
September 2007 |
(21%) |
|
July 2019 |
10% |
|
Median |
14% |
Data source: Trading Economics.
As shown, since 1984, the S&P 500 has returned a median of 14% during the one-year period following the first rate reduction in a cutting cycle. That pattern makes sense. Cheaper credit encourages consumer spending and business investments, which should drive robust financial results and share price appreciation across the stock market.
That said, how the stock market performs following the onset of a cutting cycle has historically been linked to whether the economy avoids a recession. Specifically, a recession occurred no more than 12 months after the three cutting cycles that started in 2001, 2007, and 2019. The S&P 500 declined by a median of 14% during the year following the onset of those cycles.
Comparatively, the economy did not suffer a recession within 12 months of the other eight cutting cycles, and the S&P 500 achieved a median one-year return of 18%. That bodes well for investors. Economist surveyed by The Wall Street Journal in July estimated the probability of a recession within 12 months at 28%, the lowest reading in more than two years.
Additionally, analysts at Goldman Sachs recently weighed in on the situation, saying, “With recession risk currently low and the Fed’s move appearing to be a policy normalization, we believe equities can continue to see positive momentum, absent any severe economic deterioration.”
Investors should be cautious in the current market environment
While history says the S&P 500 could climb higher over the next year, one argument against that outcome is its elevated valuation. The S&P 500 currently trades at 21.4 times forward earnings, a significant premium to the five-year average of 19.5 times forward earnings. That multiple means many stocks are expensive by historical standards, which could lead to a market correction at the first sign of trouble.
Additionally, the S&P 500 has a median year-end target of 5,600 based on the aggregate estimates from 14 Wall Street analysts. That forecast implies nearly 3% downside from the current level of 5,750. The highest target of 6,100 comes from BMO Capital Markets, while the lowest target of 4,200 comes from JPMorgan Chase.
With valuations elevated and analysts predicting the S&P 500 will decline in the coming months, investors should be cautious in the current market environment. That does not mean avoid stocks entirely, but rather be particularly choosy about which stocks are worth buying.
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History Says the Stock Market Will Make a Big Move Now That Interest Rates Are Falling was originally published by The Motley Fool