Why we’re confident stocks will rise on rate cuts

Yesterday, the US Federal Reserve cut interest rates for the first time since the outbreak of COVID-19 four years ago. And after initially slipping in response to the jumbo cut of 50 basis points, the stock market is now rising to all-time highs.

This behavior is not unusual.

We knew going into this Fed meeting that a big rate cut was likely to cause a panic-like reaction in risk assets. That’s because it could be seen as a sign of an impending recession.

But as mentioned before, the US economy has managed to avoid a recession so far. Furthermore, the data suggests that it will continue to easily navigate any downside risks.

Now, as it happens, as the economy avoids a recession while the Fed cuts rates, S&P 500 tends to increase in the three, six and 12 month periods after the first reduction. And in fact, given the nature of yesterday’s rate cut, history strongly suggests so stocks will increase in the following year.

History provides a roadmap after the rate cut

The current Federal Reserve rate-cutting cycle has just begun with stocks at all-time highs.

This has happened before – in fact, it’s happened about 20 times since 1980. That is, over the past ~45 years, the Fed has cut interest rates while stocks have been at 2% from about 20-year all-time highs times before.

Each time, the stocks rose a year later, with an average return of nearly 15%.

In other words, history shows that when the Fed cuts interest rates with stocks near all-time highs, stocks almost always rise the following year.

Well, that’s exactly what happened yesterday. So does this mean stocks will be headed for the moon next year?

We think so – because it is about more than the market. It’s also about the economy. And right now, according to real-time GDP estimates, the US economy is growing at a ~3% pace, with jobless claims around 1.8 million claims.

In other words, the US is still experiencing good economic growth with low unemployment.

So that means the Fed just cut interest rates while the economy is still growing and unemployment is still low. This has happened before. In 1987, 1989, 1995, 1998 and 2019, the central bank began a cycle of interest rate cuts while GDP was mostly running north of 3% and jobless claims were mostly below 2.5 millions. Each time, the stock rose in the following year, with an average return of 17%.

Now, nothing is certain; we live in a pretty unpredictable world, after all. But given this strong historical precedent, it looks like there is a good chance that the stock will make gains in the market in the coming year.