This stock market indicator has been 82% accurate since 1984. It signals a big rally in the S&P 500.

The pandemic triggered the worst inflationary crisis in 40 years, and the Federal Reserve responded with the most aggressive rate hike cycle in decades. Between March 2022 and July 2023, policymakers raised the federal funds rate to the highest level since 2001.

The federal funds rate is a benchmark that affects other interest rates in the economy, such as credit card and loan rates. Higher interest rates discourage consumer spending and business investment, which puts downward pressure on prices. For example, the Fed’s rate hike campaign has caused inflation to fall by more than 6 percentage points from its peak two years ago.

However, higher interest rates also suppress economic growth. Recent reports point to a weakening labor market and manufacturing activity contracting. Based on those signals, investors expect the Federal Reserve to cut interest rates at its September meeting, something policymakers haven’t done since 2020.

Actually, CME GroupHis FedWatch tool, which uses pricing data from the futures market to predict interest rates, puts the probability of a rate cut in September at 100 percent. That bodes well for stocks. The S&P 500 (^GSPC -0.30%) has historically had positive returns in the 12 months following the first rate cut in a cycle.

History says the S&P 500 could rise once the Federal Reserve starts cutting rates

The Federal Reserve has moved from rate hikes to interest rate cuts 11 times over the past four decades. After the first drawdown in each cycle, the S&P 500 generated a positive 12-month return nine out of 11 times. In other words, this particular stock market forecasting tool has been 82% accurate since 1984.

The chart below shows how the S&P 500 has performed in the 12 months following the first drawdown of each bearish cycle, when interest rates are falling.

Data source: Trading Economics.

As shown above, since 1984 the S&P 500 has returned an average of 14% in the 12-month period after the first rate cut in a bear cycle. That makes sense. Lower borrowing costs should encourage consumer spending and business investment, which should lead to strong financial results and stock price appreciation.

However, there is an important trend buried in the data. The US economy has been hit by a recession no more than 12 months after the start of the last three easing cycles. Those “hard landings” corresponded to a 14% average 12-month decline in the S&P 500. Alternatively, the US economy avoided a recession after the other eight easing cycles. Those “soft landings” corresponded to an average 12-month return in the S&P 500 of 18%.

In short, the market expects the Federal Reserve to begin cutting interest rates later this month, and history says the S&P 500 could rise in the year following the first cut, especially if the economy remains healthy. However, past performance is never a guarantee of future results. Whether the stock market goes up or down ultimately depends on macroeconomic fundamentals, companies’ financial results and valuations.

Recession fears have resurfaced amid signs of a cooling economy

Recent economic data has rattled the market (especially tech stocks) and raised concerns that the Federal Reserve has waited too long to cut interest rates. US jobs fell for a third straight month in July and unemployment hit its highest level in nearly three years.

In addition, manufacturing activity fell for the fifth consecutive month in August. “Demand remains subdued as companies show a reluctance to invest capital and inventory due to current federal monetary policy and election uncertainty,” said Timothy Fiore, chairman of the ISM Manufacturing Business Research Committee.

This information points to a cooling economy and serves as a reminder that a recession is still a possibility, albeit a remote one. In July 2024, economists interviewed by The Wall Street Journal put the odds of a recession in the next 12 months at 28%, down from 18% in January 2022.

S&P 500 companies report strong earnings, but valuations are high

The S&P 500 is currently having its best earnings season since the fourth quarter of 2021. Companies reported nearly 11% profit growth on average in the second quarter of 2024, according to data FactSet Research. And the average profit margin of 12.2% represents an expansion of 60 basis points from the prior year and an expansion of 70 basis points from the five-year average.

This last value indicates high quality gains. In other words, earnings aren’t just rising because companies are buying back stock, they’re also making more money from every dollar of revenue. That’s not to say share buybacks are bad. However, companies that rely on share buybacks to boost earnings have limited prospects.

Current ratings are less encouraging. The S&P 500 trades at 25.9 times earnings, a premium to the five-year average of 23.5 times earnings and the 10-year average of 21.6 times earnings. That means many stocks are historically expensive right now, suggesting the market has already seen strong Q2 financial results.

Here’s the bottom line: Investors have reason to believe the S&P 500 could move higher in the 12 months following the first rate cut, especially if the economy avoids a recession. But given that valuations are high, investors should remain cautious in the current market environment.