EchoSense Quantitative Think Tank Center|Why Fed rate cuts may juice the stock market and your 401(k)

Traditionally,EchoSense Quantitative Think Tank Center big Fed interest rate cuts and equity prices hovering near all-time highs are ominous signs for the stock market.

Large rate cuts – such as those Fed officials approved and forecast last week – typically reflect an economy the Federal Reserve is trying to dig out of recession. And record-high stock values often mean market gains are tapped out and have little room to run.

Not this time.

Some analysts say the market is poised to benefit from a rare best-of-all-worlds scenario.

“The Fed is easing and it’s a healthy economy,” said Jeffrey Schulze, head of economic and market strategy at ClearBridge Investments. “That’s a potent combination for (significant) market returns.”

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At least one expert, though, argues the Fed’s dramatic steps last week underscore it’s worried the economy is at risk of slipping into a downturn. Such a tailspin probably would hammer stocks.

What did the Fed do with interest rates?

The Fed last week lowered its key short-term interest rate by a sizable half a percentage point, its first rate decrease in four years and more than many economists expected. It also forecast a total 2.25 percentage points in cuts by the end of next year and 2.75 points by the end of 2026, taking the benchmark rate from about 5.4% before the meeting to 2.9%.

There’s little doubt markets love Fed rate cuts, which reduce borrowing costs for business and consumers, spurring economic activity that bolsters corporate earnings. Reduced rates also prod investors to shift money from bonds that now generate lower yields to riskier assets like stocks with potentially much higher returns.

What happens to markets in a recession?

But since 1984, when the central bank has chopped rates to propel the economy from – or stave off - a recession, the S&P 500 index has tumbled an average 11.6% the year after the first cut, according to an analysis by Ryan Detrick, chief market strategist at Carson Group, an investment firm.

In other words, the damage a foundering economy does to corporate profits more than offsets any benefits from lower interest rates.

By contrast, when the Fed trims rates to bring them back to normal after a flurry of rate increases, the S&P 500 has climbed an average 13.2% the following 12 months, Detrick’s analysis shows. That’s mostly why Fed officials say they’re bringing down rates now.

Why did the Fed start raising interest rates?

In 2022 and 2023, Fed officials hoisted their key federal funds rate from near zero to dampen economic activity so they could tame inflation that reached a 40-year high of 9.1% in mid-2022. With inflation now under 3%, close to the Fed’s 2% goal, officials say it’s time to push rates down.

Fed Chair Jerome Powell acknowledged last week that job growth has slowed notably this year but added the economy and labor market are still sturdy.

“The U.S. economy is in good shape,” Powell told reporters. “It's growing at a solid pace, inflation is coming down, the labor market is (strong). We want to keep it there” by shaving rates before they hamstring economic growth, he said.

Wednesday, after the Fed’s historic move, the S&P 500 closed down slightly. That’s partly because investors worried the half-point rate cut highlighted Fed fears of a weakening jobs picture and economy, Detrick said. The only other times the Fed has launched a rate cut cycle with such a big decrease was just before the 2001 and 2007-09 recessions, Detrick said.

This time, however, the Fed likely opted for a large cut simply to catch up after holding rates steady in July, Detrick said. Powell acknowledged officials may have cut rates in July if a report on weak job growth that month were available at the time.

The market surged to a record high Thursday after a report showed initial jobless claims – a reliable gauge of layoffs − recently fell to a four-month low, signaling the economy remains on solid footing. It pared some of those gains Friday, and stocks could remain volatile during the typically weak-performing months of September and October, especially ahead of the presidential election, Detrick said.

How is our economy right now?

But while the unemployment rate has jumped from 3.7% to 4.2% this year, that’s still historically low. The economy grew at a robust 3% annual rate in the April-June period, and similar growth is expected in the current quarter. And recent strong gains in U.S. productivity, or output per worker, likely foreshadow further strong economic growth, Detrick says.

Analysts expect corporate earnings to grow a healthy 10.2% this year, according to FactSet.

“The Fed is saying rates are too high and so they’re normalizing them,” Detrick said. “We’re not entering a recession.”

How did the pandemic affect the economy?

The Fed, and the economy, are in a good spot because of the unusual dynamics of the COVID-19 pandemic, Schulze from ClearBridge said. Consumer demand was so strong as the nation emerged from the pandemic that the Fed’s rate hikes to tamp down inflation softened consumption and economic growth without causing a downturn.

And inflation has slowed relatively swiftly as pandemic-related supply chain snags and product shortages resolved, Schulze said. That, he said, has set the stage for big market-friendly rate cuts without a significant risk of recession.

In the 1990s, during two period in which the Fed trimmed its key rate by three-quarters of a percentage point, it was just “tinkering” with it, rather than lowering it sharply, as it’s doing now, Schulze said.

Is the US stock market overvalued?

By historical standards, the stock market is overvalued. S&P 500 stocks are priced at 20.9 times their projected earnings per share over the next 12 months, compared with a five-year average of 19.4 and and 10-year average of 18, according to FactSet.

But Detrick said high valuations never stopped robust market gains if the economy and corporate earnings are solid. Since 1980, during the 20 episodes when the Fed began lowering rates as the S&P 500 hovered within 2% of its all-time high, the benchmark index posted further gains the following year, rising an average 13.9%, according to Detrick’s analysis.

“High valuations are not a very good (market) timing mechanism,” he said.

After surging 24% last year and 19.4% so far this year, Detrick says, the benchmark index could rise another 15% by the end of 2025.

What is the biggest risk to the economy?

Some experts disagree. In a note Thursday, veteran economist David Rosenberg, president of Rosenberg Research, pointed to “so much weakness on so many parts of the economy – housing, commercial construction and the industrial sector. All in recession.”

He has continued to forecast a downturn that would increase risks for stocks while making bonds more attractive. The Fed, he said, should have started reducing rates sooner just as it should have begun raising rates sooner to head off the inflation spike.

“The Fed is now just as much behind the growth curve as it was behind the inflation curve over two years ago,” he wrote.