Will the stock market rally if the Fed cuts rates in September? This is what history shows.

Federal Reserve Chairman Jerome Powell mentioned two factors that could lead to a rate cut. One was inflation falling to near the Fed’s 2% target. The other was a weakening labor market.

Both boxes are now checked. The Fed’s favorite measure of inflation — the price index for personal consumption expenditures (PCE) — fell to 2.5 percent in June. July jobs were weaker than expected.

The likelihood of a short-term interest rate cut has increased. But will the stock market rally if the Fed cuts rates in September? This is what history shows.

Image source: Getty Images.

Looking back

The Fed has cut interest rates 28 times so far this century. These rate cuts came in bursts six times.

In early 2001, the Fed began a series of 11 interest rate cuts. At first, these reductions were mainly due to the US recession following the bursting of the dot-com bubble. The terrorist attacks of September 11, 2001, provided another catalyst for Fed action. How did the stock market respond? Not very well.

^ SPX data by YCharts.

Although that recession ended in November 2001, the subsequent recovery was not very strong. The Fed stepped in with a further rate cut in November 2002 S&P 500 it did not immediately respond, and even declined in the first quarter of 2003. However, the index rebounded strongly in March. The Fed cut rates again by 0.25% in June 2003. Again, stocks didn’t move much right away. However, the uptrend soon resumed.

^ SPX data by YCharts.

Four years have passed without any changes in interest rates. However, the collapse of the housing market in the second half of 2007 caused the Fed to move. It cut rates in September 2007 and then went on to cut rates six more times through April 2008. These actions were not enough to prevent a significant decline in the S&P 500.

^ SPX data by YCharts.

Then came the stock market crash of October 2008. The US economy was in such a severe decline that it became known as the Great Recession. The Fed cut interest rates by 0.5% twice in October, followed by a 1% cut in December. The S&P 500 initially fell, but has rebounded since March 2009.

^ SPX data by YCharts

More than a decade has come and gone. The US economy and stock market are back. However, in August 2019, the Fed began what Powell called a “mid-cycle adjustment.” It has cut rates by 0.25% three times, with the last cut on October 31, 2019. The initial cut did not appear to cause any stock market reaction. However, the S&P 500 took off after the Fed’s October move.

^ SPX data by YCharts.

The COVID-19 pandemic prompted the Fed to cut rates twice in March 2020. Although the S&P 500 initially fell, it quickly recovered.

^ SPX data by YCharts.

Why the mixed results?

As we’ve seen, there have been mixed results in the stock market when the Fed has cut rates in the past. Why hasn’t the S&P 500 always jumped on what should have been seen as good news by investors? It’s complicated.

In some cases, the Fed’s moves simply weren’t enough to immediately offset severe economic or geopolitical challenges. For example, interest rate cuts were not enough to calm investors after the 9/11 attacks or the 2008 stock market crash.

At other times, investors might have decided to wait and see if the rate cut would make a big enough difference to warrant more optimism.

The Fed also often telegraphs its moves well in advance. When investors anticipate rate cuts, they can start buying before they happen. Effective rate cuts could become virtually a non-event for the stock market.

Good investment ideas if a rate cut is on the way

The history lesson here is simple: Don’t bet on stocks going up just because the Fed is cutting rates. It might, but it might not. However, I think there are some good investment ideas if a rate cut is indeed on the way (either in September or in the coming months).

Long-term bonds typically rise when interest rates fall. The Vanguard Long Term Bond ETF (BLV 0.90%) is a smart way to play this trend. This exchange-traded fund (ETF) holds nearly 3,100 long-term bonds and has a low annual expense ratio of 0.04%.

I like it too Vanguard Small Cap Value ETF (VBR 0.14%). Small-cap stocks often rise when rates are low. Smaller companies often have a higher percentage of debt than larger companies. Lower rates reduce their interest expenses.