Interest Rates May Do Something Not Seen Since 2020. A Big Move in the Stock Market Usually Follows.

Federal Reserve officials will meet on Sept. 17 and Sept. 18 to review economic data and adjust monetary policy as necessary. The market expects the committee to cut the benchmark federal funds rate for the first time since 2020, setting in motion a sequence of events that will lower other interest rates and encourage economic growth.

Policymakers will most likely start with a quarter-percentage-point cut. However, inflation reached a three-year low in August, and unemployment hit a three-year high in July, which leaves room for a larger reduction in rates. Indeed, futures prices imply a 15% chance of a half-percentage-point cut at the September meeting.

Historically, rate cuts have been a positive catalyst for the S&P 500 (^GSPC 0.54%), an index widely seen as the best barometer for the overall U.S stock market. Here’s what investors should know.

History says the S&P 500 could soar when the Federal Reserve cuts interest rates

Since 1984, the Federal Reserve has steered the economy through 11 loosening cycles — that is, 11 periods during which interest rates were declining. In most cases, the S&P 500 produced a positive return during the 12-month period following the first rate cut in each cycle, as shown in the chart below.

Data source: Trading Economics.

As shown above, during the last four decades, the S&P 500 returned a median of 14% during the 12 months following the first rate cut in a loosening cycle.

Interestingly, if performance is analyzed based on the size of the first rate cut, the S&P 500’s median 12-month return was 16% during loosening cycles that started with a quarter-point reduction. By comparison, its median 12-month return was 13% during loosening cycles that started with a half-point reduction.

Additionally, recessions have played critical role in determining how the S&P 500 performs. Following the last three cycles, the U.S. economy suffered a recession within one year of the first rate cut, and those events corresponded with a median 12-month decline of 14% in the S&P 500. But no recession occurred within a year of the other eight cycles, and those events corresponded with a median 12-month gain of 18%.

In short, history says the S&P 500 could soar if the Federal Reserve cuts rates in September, provided the economy avoids a recession. But there are two big asterisks by that statement. First, no stock market indicator is perfect. Second, how the S&P 500 performs in the coming months depends on company-level financial results and valuations.

Wall Street forecasts 13% upside in the S&P 500 over the next year

S&P 500 companies reported 11.3% earnings growth in the second quarter of 2024. That is the highest growth rate since the fourth quarter of 2021, according to FactSet Research. Better yet, Wall Street analysts estimate full-year earnings will increase 10.1% in 2024 and then accelerate to 15.4% in 2025. That would be the highest annual earnings growth rate since 2018.

However, elevated valuations suggest those estimates have already been priced into the market. The S&P 500 currently trades at 20.6 times forward earnings, a premium to the five-year average of 19.4 times forward earnings and the 10-year average of 18 times forward earnings. “Momentum has been the driving force in the U.S. market, and the characteristics of the stocks with the best momentum have become increasingly risky,” according to Paul Quinsee at JPMorgan Chase.

Even so, Wall Street analysts generally expect the S&P 500 to maintain its momentum over the next year. The index has a bottom-up target — which is calculated by aggregating the median target price estimate for every stock in the index — equal to 6,275, which implies 13% upside from its current level of 5,555 over the next 12 months.

Investors should bear in mind that past performance is never a guarantee of future results, and forecasts like price targets and earnings estimates are inherently unreliable. Warren Buffett once wrote, “Short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.”

Having said that, I think patient investors can put money into the stock market today, provided they follow a few simple rules: (1) Never buy a stock if you don’t understand the business, (2) never buy a stock you aren’t comfortable holding for three to five years, and (3) never buy a stock without considering its valuation.

To be clear, that does not mean the S&P 500 will continue rising in the coming months. The index will almost certainly decline sharply if the economy slips into a recession. However, drawdowns are a great time to buy good stocks, so investors should lean into any weakness in the market. To quote Mary Park Durham at JPMorgan, “Investors should view pullbacks as an opportunity to step out of cash and ensure proper diversification.”