Analysis-Rate cuts are here, but US stocks may have already priced them in By Reuters

By Lewis Krauskopf

NEW YORK (Reuters) – As the Federal Reserve begins a long-awaited rate-cutting cycle, some investors are wary that value-rich U.S. stocks may have already reaped the benefits of easier monetary policy, making for the markets to grow much more. .

Investors on Thursday cheered the first interest rate cuts in more than four years, sending the new records to a day after the Fed cut borrowing costs by 50 basis points to support the economy.

History supports such optimism, especially if the Fed’s assurances of a still-healthy US economy pan out. The S&P 500 has gained an average of 18% a year after the first rate cut in an easing cycle, as long as the economy avoids recession, according to Evercore ISI data since 1970.

But stock valuations have risen in recent months as investors anticipate Fed cuts in stocks and other assets seen as benefiting from looser monetary policy. That made the S&P 500 trade at more than 21 times forward earnings, well above its long-term average of 15.7 times. The index has climbed 20 percent this year, even as U.S. employment growth has been weaker than expected in recent months.

As a result, in the short term “the upside from lower rates is somewhat limited,” said Robert Pavlik, senior portfolio manager at Dakota Wealth Management. “People are getting a little nervous about 20% growth in an environment where the economy has cooled.”

Other valuation measures, including price-to-book and price-to-sales, also show the stocks are well above their historical averages, Societe Generale (OTC:) analysts said in a note. For example, US stocks trade at five times their book value, compared to a long-term average of 2.6.

“Current levels can be summed up in one word: expensive,” SocGen said.

Lower rates will help stocks in several ways. Lower borrowing costs are expected to boost economic activity, which can bolster corporate earnings.

A drop in rates also lowers returns on cash and fixed income, making them less of an investment competitor to stocks. The yield on the benchmark 10-year Treasury is down about a percentage point from April to 3.7 percent, though it has risen this week.

Lower rates also mean future corporate cash flows are more attractive, which often boosts valuations. But the P/E ratio for the S&P 500 has already rebounded substantially after falling to 15.3 at the end of 2022 and 17.3 at the end of 2023, according to LSEG Datastream.

“Equity valuations have been pretty full on that,” said Matthew Miskin, co-chief investment strategist at John Hancock Investment Management. “It’s going to be hard to replicate the multiple expansion that you just got in the last year or two over the next couple of years.”

With any further valuation gains expected to be limited, Miskin and others said earnings and economic growth will be the key drivers of the stock market. S&P 500 earnings are expected to rise 10.1% in 2024 and another 15% next year, according to LSEG IBES, and the third-quarter earnings season starting next month will test valuations.

At the same time, there are signs that the promise of lower rates may have already attracted investors. While the S&P 500 has tended to be flat in the 12 months leading up to rate-cutting cycles, it’s up nearly 27% over that period this time around, according to Jim Reid, global head of macro and thematic research of Deutsche Bank, which data studied since 1957.

“You could argue that some of the potential gains of a ‘recession-free easing cycle’ have been borrowed from the future this time,” Reid said in the note.

Certainly, many investors are not deterred by the high valuations and maintain a positive outlook for the stock.

Valuations tend to be a difficult tool to use to determine when to buy and sell stocks — especially since momentum can keep markets rising or falling for months before returning to historical averages. The forward P/E ratio for the S&P 500 has been over 22 times for much of 2020 and 2021 and reached 25 during the dotcom bubble of 1999.

Meanwhile, rate declines near market highs tend to bode well for stocks a year later. The Fed has cut rates 20 times since 1980, when the S&P 500 was 2 percent off its all-time high, according to Ryan Detrick, chief market strategist at the Carson Group. The index was higher a year later each time, with an average gain of 13.9 percent, Detrick said.

“Historically, equity markets have performed well during periods when the Fed cut interest rates while the US economy was not in recession,” UBS Global Wealth Management analysts said in a note. “We expect that this time will be no exception.”